Question: What do you call a rogue trader that hasn’t been caught?

Answer: Managing director

In January 2008, Société Générale lost billions due to an alleged rogue trader named Jérôme Kerviel. During my time working at the Federal Reserve, I was part of a team sent to SocGen to investigate. (Very interesting times in retrospect.)

60-second primer on risk management
As a brief primer on risk management: every trader is given limits to which they must adhere. For example, they have limits on how much they can lose each day. They have limits on how much VaR (value at risk) they can have. Depending on the asset they are trading, they’ll have more product-specific limits—such as delta (ie, the sensitivity of an option to price changes in the underlying security), CS01s (ie, what happens when credit spreads widen 1bp), etc.

So, SocGen is claiming that Mr Kerviel blew through his limits, hid the trades, and no one knew about it. And to add insult to injury, when SocGen went to unwind his positions in January 2008, they threw the market into a tailspin.

Cultural attitudes towards risk management
While I can’t say for sure—and actually wouldn’t be allowed to even if I knew—it’s very hard to imagine that no one knew what was going on. In fact, that raises an interesting question that I always thought about while working at the Fed. How do cultural attitudes inform risk management practices? Did the team in Paris know about the limit breaches and turn a blind eye? Would that same behavior take place in a German bank? How do Japanese banks manage their risk—and more specifically, their limits—as compared to their Western counterparts? I spent a number of years doing examinations in foreign banks—so I’m more than happy to share my thoughts over a few drinks (don’t worry, I’m a cheap date).

Compensation structures
This case also forces us to revisit the issue of compensation structures. In particular, how do companies encourage greater accountability among employees through compensation? If Mr Kerviel's performance was tied to how well he managed his limits, I can almost guarantee you that those trades would have never taken place.

Principal-agent dilemma
Furthermore, isn’t this a classic example of the principal-agent dilemma? What happens when a company ("prinicipal") hires an employee ("agent") who is pursuing their own interests at the expense of the company? The answer is simple--MF Global, Mr Kerviel, Barings Bank, et al.

Well, it will be interesting to see how Mr Kerviel’s appeal unfolds—especially as some observers find SocGen’s account a bit dubious.