There’s nothing like a massive fraud to really capture the public’s imagination. The revelation that a single rogue trader caused French bank Société Générale to suffer a e5bn loss has dominated the agenda this week inside and outside the City, even briefly diverting attention from the dire state of the global economy.
The fact that a 31-year-old trader acting alone and for no obvious personal gain was able to run up a derivatives exposure to European stockmarkets of e50bn – the equivalent of the GDP of Afghanistan– without detection has only added to the mystery. How can this sort of thing happen? Why did no one notice? What are the odds this is going on at other banks?
Clearly SocGen is guilty of shocking management failures. But any schadenfreude felt in the City at the fate of the recently-anointed “Equity Derivatives House of the Year” is tempered by the knowledge that no bank is safe. Every bank harbours its potential Jerome Kerviels – greedy traders whose ambitions exceed their talents. The incentive structures built into the system are so skewed (huge bonuses for those who win, lost jobs for those who fail) that some people will inevitably be tempted to break the rules to get ahead.
During booms, these gambles may pay off. It’s when booms turn to busts that frauds come to light. Think of Enron, WorldCom, Tyco and Parmalat in the wake of the dotcom bust, or the collapse of Drexel Burnham in the 1980s. The late JK Galbraith invented a useful word for this: he called it the bezzle: “the inventory of undiscovered embezzlement” that comes to light after a boom. SocGen may have been the first big scandal of this bust, but it is unlikely to be the last.
That’s certainly one more thing for investors to worry about in the current turmoil. Apart from the hammering meted out to SocGen shares, the operation to unwind the bank’s massive exposure to the market contributed to the wild swings in share prices last week – and may even have influenced the Fed’s decision to make an emergency 0.75% cut in rates. Frauds such as these are the “unknown unknowns” of the markets.
Still, shocking as the SocGen debacle may be, it is not nearly as alarming as the losses the banks are continuing to rack up without any assistance from fraudsters. The real scandal here is the way some of the biggest names in global finance – UBS, Citigroup, Merrill Lynch – have been able to lose billions while apparently following the rules: across the board, the subprime debacle has shown rules are no defence against greed and stupidity.
That’s important, because there is bound to be a lot of discussion over the next few months and years about how to change the rules. Gordon Brown met this week with German Chancellor Angela Merkel and French President Nicolas Sarkozy to discuss reforms to the financial system. At times of crisis, there is huge pressure on governments to act. But government action often does more harm than good.
The best corrective is to ensure that those responsible pay the price for their folly: bankers lose their jobs and investors lose their shirts. That way, the system is more likely to correct itself. The risk is that governments do the opposite: prop up banks and markets and introduce knee-jerk, poorly thought-out reforms that clog up the system and delay recovery.
Think of the 1930s Wall Street reforms that arguably prolonged the Great Depression, or the way the Sarbannes Oxley Act brought in in the wake of the dotcom bubble drove business from New York. Western governments should be careful their response to the SocGen fraud and subprime debacle does not accelerate the shift in global power to the East.
The lesson we learn from Suharto
The death of President Suharto, the former dictator of Indonesia, divided opinion around the world – and prompted a heated debate in my office. According to one school of thought, Suharto may have been responsible for over one million deaths, run a repressive regime and embezzled billions of dollars, but he wasn’t nearly as corrupt as some dictators and actually pursued sensible economic policies that saw the country’s GDP grow fourfold during his 30-year rule. For that reasons, Indonesians should be grateful to him.
I’m not convinced. First, there are more important criteria by which to judge a political leader’s career than economic performance – not least freedom from tyranny. Second, I think it’s impossible to judge a political career in isolation from what came after: in this case, a massive economic slump that took the gloss off Indonesia’s performance under Suharto and major outbreaks of fighting.
The problem with dictators is that no matter how successful their policies in the short-term, there is always the risk their regime will come to a bloody end – or that they will undo all their good work trying to stay in power. Good examples of this are Kenya and Zimbabwe. This is particularly worth bearing in mind as global power shifts East to countries that are far from liberal democracies.