Société Générale Crisis Highlights ‘Rogue Trader’ Risk Warns Lloyd’s

January 30, 2008

The ongoing crisis at the second largest French bank, Société Générale, has prompted Lloyd’s to remind the financial community of some unfortunate facts. The bank lost €4.9 billion, or $7.25 billion, after it was forced to close out positions taken by a “rogue trader” in excess of his authorized limits.

In a bulletin on its web site (www.lloyds.com) Lloyd’s said the “incident demonstrated that large, well-established banks with rigorous risk management procedures face serious risks of internal fraud – and that risk management procedures can, and do, fail. The Société Générale revelations raise major questions about the nature of risks that financial institutions are facing and how companies can mitigate those risks.”

According to Mark Johnson, Underwriting Risk Officer at Talbot Underwriting Ltd. and an expert in financial institutions cover, “rogue traders are one of the largest operational risks financial institutions face.” He then suggested that insurance could be one possible solution to deal with that threat.

Daniel Butler, executive director of Aon’s financial institutions team, explained: “Financial institutions will have fidelity bonds that cover fraud for personal gain.” However, in this case the trader, Jérôme Kerviel, has not been accused of personally profiting from the unauthorized trades. Butler pointed out that “other motives can leave banks without protection. For example, Nick Leeson left Barings exposed because his illegal actions were found to be in support of the company balance sheet.”

Most banks buy bankers blanket bonds which cover employee dishonesty but again coverage is only triggered in the event that an employee is motivated by personal gain. Banks could typically purchase as much as £500 million cover in the London market for this type of cover.

“However,” Lloyd’s warns, “motives other than personal gain, as may prove to be the case with Société Générale, can leave banks liable. A second product called professional indemnity cover with a dishonesty extension, covers a bank in the event of a claim by a client where an employee trades the client’s funds dishonestly. However, crucially, neither of these covers offers protection in the event that an employee trades the bank’s own funds unlawfully.”

The situation led Lloyd’s to develop a product to cover this risk following the Nick Leeson incident. It launched a product called “Unauthorized Trading cover. The coverage protects banks in the event of unauthorized trading by an employee in relation to the bank’s own funds, filling the gap that existed.”

According to Butler: “Employee fraud, and in particular unauthorized trading, is insurable but the challenge is persuading banks to admit such exposure exists.” Lloyd’s confirmed that many of its underwriters consider the coverage a “hard sell, with many companies believing that their internal controls are sufficient, although the Société Générale case may start to overturn those assumptions.

Johnson added that “many companies are left exposed because they assume that their internal controls are strong enough to protect them. Lloyd’s underwriters would normally send in value-added independent surveyors to recommend the best control practices.”

Though the scale of the fraud with Société Générale was so staggering that an insurance policy wouldn’t have made a dent in covering it, Richard Norris, underwriter at Novae points out that most cases of unauthorized trading would fall within the limits of a policy. A typical policy would give up to £200 million ($397 million) capacity, offering not only financial redress, but also some reputational cushioning for a company when the story hits the press.

Johnson indicated that following the case of Société Générale companies might be encouraged to change the way they deal with the latent risk of rogue traders. “underwriters will expect to see an increased number of inquiries to purchase cover in the coming weeks and months.” At the very least, it will raise awareness that risks are real and internal processes can fail.

Source: Lloyd’s

Topics Excess Surplus Fraud Underwriting Lloyd's

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