Compliance Versus Ethics: Lessons from a French Bank Fraud
Jan 28th, 2008 • Posted in: Commentaryby Rushworth M. Kidder
Okay, naptime’s over. That persistent crashing noise we heard all last fall — the sound of mortgage-lender portfolios caving into rubble — should have roused us. But only last week, when a hurricane-force fraud blew the roof off French bank Société Générale, did we finally wake up.
What we’re now seeing, as we rub our eyes, is a truth as vast as it is unfamiliar: that capitalism can’t survive in the absence of integrity.
If that seems an overstatement, let me explain. For decades, ethics has been viewed in much of the business community as a soft topic. Some business schools, to be sure, have instituted small but lively ethics programs. And many strategists would agree that if you can manage to fit ethics into your corporate framework, you’ll reap pleasant honors and appreciative comments. But competitive capitalism is still largely understood to require something other than the core values of honesty, fairness, responsibility, and respect.
As a result, the fallacy has grown up in some circles that moral values are irrelevant. Why? Because we have all these regulations. Get the rules right (the argument goes), enforce them vigorously, set up risk-control offices to assess the dangers and enforce obedience, and you won’t need ethics. All you’ll need is compliance.
The result of that fallacy is now painfully clear: a $7.2 billion loss last week for Société Générale, based on trades initiated by a 31-year-old employee named Jérôme Kerviel. Because Kerviel had worked for several years in the bank’s risk-control area, he easily evaded the regulations. Even as late as November, when Eurex, the derivatives exchange unit of Deutsche Börse, raised questions with Société Générale about some of Kerviel’s trading positions, he produced fake paperwork to cover his tracks.
According to the bank’s initial assessments, Kerviel was a rogue trader working alone — hacking into computers, borrowing other employees’ computer passwords, and falsifying documents. By the time he was discovered, he had placed bets in the marketplace worth $73.5 billion — more than the bank’s market worth. He appears not to have profited personally from his trades, nor to have wanted to harm Société Générale. His goal, according to the Paris prosecutor in the case, was to enhance his reputation and become a star trader.
There’s a lot we don’t yet know about the Kerviel case — whether the bank turned a blind eye to his deceptions because of his prior successes, whether others at his level were doing similar things, whether he was a scapegoat to turn attention away from the bank’s mounting losses in the subprime market. But even in its early stages, his case raises serious questions about the limits of risk control:
- The derivatives market in which Kerviel worked is a specialized arena depending on complex mathematical formulas and sophisticated computer technologies. It became part of the bank’s business in 1987 — and is unlike anything that earlier generations of traders had experienced. As Kerviel proved, the scale and technological refinement of this business allowed the unethical activities of a single individual to be amplified rapidly into a world-class calamity. Given the ability of technology to leverage ethics in this way, how complex will risk-control operations need to become — and will they end up costing more to maintain than the trades are worth?
- While such ethical leveraging is not new, Kerviel has set a record. Société Générale’s $7.2 billion loss far outweighs the damage done by Joseph Jett at Kidder Peabody in 1994 ($350 million), Nick Leeson at Barings Bank in 1995 ($1.4 billion), and Yasuo Hamanaka at Sumitumo in 1996 ($1.3 billion). This trend suggests that many lessons remain unlearned by risk managers — and that a lot of illicit skills can readily be acquired by today’s young traders. Is risk control largely a palliative, building a false sense of confidence while cloaking the deeper issues underlying such rogue events?
- If Kerviel’s motive was partly to prove he could outsmart the system, he may be a bellwether for a new generation of computer-genius rogues whose reward is less financial than psychic. And if, as many suspect, the termination of billions of dollars of his trades by Société Générale last week caused an already unstable market to slide toward wholesale meltdown, did he ultimately get the largest psychic buzz of all — seeing his own work steer the U. S. Federal Reserve Bank toward a historic rate cut? If this is what a single trader, motivated neither by greed nor revenge, can do in 2008, what might a malicious group of traders do in the next decade to sabotage an organization, a market, or even a nation?
Don’t misunderstand: Risk-control mechanisms are crucial and must be strengthened. But to imagine that today’s challenges can be addressed simply by better controls and tighter compliance is sheer fantasy. Which brings us back to the relationship of capitalism and ethics. The best protection any corporation can put in place is not a regime of compliance but a culture of integrity.
What if, at Société Générale, there had been a determined insistence on honesty, responsibility, fairness, and respect — not just as theories and mottos, but as practiced and admired values? What if ethics had been continuously taught, discussed, and promoted across the firm? What if an expectation of integrity had permeated the organization from the top down, reaching into every client relationship, every promotion decision, every new hire? Would rogue traders make it very far up the chain before being found out? Would even the aroma of sleaze at the desk next door have been tolerated — or would someone have had the courage early on to take Kerviel aside and point out that “we don’t do things like that around here”? Would Kerviel himself, feeling the support of a values-driven culture, either have steered himself into honest behaviors or decided to leave?
Trust, after all, is what sound capitalism always has relied on. Last week’s wake-up call reminds us that trust arises not just from a smart system of rules but from a genuine culture of integrity. If half of the effort Société Générale spent building internal controls had gone into creating a world-class culture of ethical values, does anyone really think it would be where it is today?
©2008 Institute for Global Ethics
Questions or comments? Write to newsline@globalethics.org.
Rushworth Kidder will return to this space next week.
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