Rogue Traders and the Principle Agent Problem

Jérôme Kerviel, the rogue trader at France’s Société Générale is likely to become as infamous as Nick Leeson in the annals of rogue traders who have upset the financial applecart over the years. Kerviel is estimated to have cost Societe Generale just under Euro 5 billion with this disastrous deals and one of France’s leading banks is now counting the cost and watching nervously over its shoulder for a possible takeover bid as the vultures hover.

It was fascinating listening to Nick Leeson giving his reaction to the latest rogue trading scandal in an interview on BBC news 24. The ten minute interview is well worth using with Economics students not simply because everyone likes a juicy scandal but because Leeson makes some very pertinent and important observations. one of them relates to a variant of the principal-agent problem. This occurs when managers cannot observe directly and with sufficient control the activities of the people they are supposed to be managing. In the case of Leeson who famously brought down the venerable Baring’s bank in 1995, his heavy losses trading NIMEX futures were hidden by fraudulent use of specially created accounts. Something very similar is likely to have happened with Société Générale - it is a classic case of the backroom operations not knowing what the front-end guys (i.e. the traders) are up to. The FT leader today sums up the problem

“When Nick Leeson brought down Barings in 1995 risk management became a more serious business. Banks installed sophisticated blackbox technology to prevent a repeat disaster. While lacking Mr Leeson’s star status, the backroom boy turned “vanilla” futures trader who lost €4.9bn for SocGen shows just how easy it is to dupe these sophisticated systems.”

There are strong hints that the rogue trading scandal was a major factor behind the financial turmoil and collapsing share values in international equity markets earlier on this week. The Independent reports that:

“The relatively junior bank employee, who earned less than €100,000 a year, managed to evade supposedly fraud-proof safeguards to stake an estimated €50bn – which is more than the GDP of Slovenia, Uganda or Cuba – on the future direction of European stock markets. France’s second largest bank had to scramble desperately to abandon his concealed trades on Monday and Tuesday, against the calamitous background of sharply falling European stock exchanges.”

Time for me to dust off my copy of Rogue Trader (starring Ewan McGregor) and take it into lessons next week - this is a film that A level economics students love. You can access the movie trailer here: