You can beat the system, but you can't beat the house
If responses to the SocGen scandal sound familiar, it's because they
are. The usual remedies - new guidelines for derivatives trading, tighter
trading controls and higher fines - have been trotted out after every debacle
since Enron. Unfortunately, they will be no more successful this time than
last, because they all mistake a managerial failure for a systemic one.
The truth is that
current regulatory and risk management systems are designed to retrospectively
identify at what point a thief stole your money, not to alert you when he is
actually stealing it. Asking a group of investment bankers to investigate a
fraud perpetrated against systems designed by investment bankers is unlikely to
generate a new approach. Rather than saying 'it won't happen here' (as the
French did after Parmalat), or 'it won't happen again' (after Enron, WorldCom
et al), we should be asking: are there lessons to be learnt from other
'The gambling known as business looks with austere
disfavour upon the business known as gambling,' wrote Ambrose Bierce in The
Devil's Dictionary. Gambling is highly regulated, but does not rely on
regulation to manage its internal risk; it takes that on itself.
With risk as its primary product,
gambling works on the assumption that, given the chance, everyone wants to take
money out of it - customers and staff. It also assumes most robberies are
inside jobs. Consequently, it concludes, the organisation should be watching
the people with working knowledge of the systems - such as Jérôme
Kerviel and Nick Leeson, who were familiar with their back-office set-ups - and
not the systems themselves.
Casino surveillance cameras are trained on
croupiers as well as punters. Watching the croupiers are the 'pit bosses', who
are also being watched. All are monitored for behavioural changes and unusual
patterns, whether winning or losing. When a change is seen, managers
investigate until they are satisfied with the explanation. Some large insurance
companies are doing something similar, using 'stress-detector' technology to
screen claims. Only claimants whose voice patterns exhibit anomalies are
When Kerviel's behavioural anomalies were reported, he
was apparently able to shrug them off with minimal explanation, as Leeson had
at Barings. Management wasn't managing: those in charge were either
'player-managers' more concerned with their own performance, or so far up the
chain as to be disconnected from the game.
Perhaps the most damning
comment in the Barings affair was that of a very senior official who saw no
reason for concern because Leeson's trading showed 'nothing extraordinary'.
Actually, his results were so contrary to both his own previous results and
that of his peers that he warranted immediate investigation. The senior manager
had no idea his results were unusual - he just saw them as good. The same was
true of John Rusnak, the currency trader who lost £354m at Allied Irish,
of Kerviel, and no doubt many others.
According to the investigation by
the governor of France's central bank, Christian Noyer, SocGen's controls were
'not followed up appropriately'. In other words, there were no 'floor walkers'
or 'pit bosses'. Even if the surveillance systems were effective, management's
actions were not.
This is a direct consequence of the flattening of
organisational structures. What has been flattened, by and large, is the
'monitoring' function traditionally carried out by long-serving middle-managers
with elephant-like corporate memories who could intuitively spot behavioural
Psychologist Gary Klein calls this 'recognition primed
decisions': you might know it as 'experience'. The gambling industry relies on
this monitoring function to bolster its technical systems and guarantee its
internal risk management. It is the manager who activates the deep
investigation, not the system.
Gambling has another invaluable lesson
for the financial markets: the simplicity of its terminology. For example, it
has only one term for all the activities it covers - betting. A government
supposedly dedicated to educating the public in the intricacies of financial
services would do well to copy this appproach. Whether you 'invest' in a
building society, derivatives, credit derivatives, options or futures, you are
betting that the return will outweigh the risk. In casinos, everyone
understands that there is no such thing as zero risk and no such thing as
Perhaps the sharpest lesson from gambling is that
if someone is playing with my money, I watch them especially carefully. I was
once asked to follow a colleague at a small bookmakers where I worked and
report on his movements. It turned out that he was the 'runner' who 'laid off'
big bets. When the shop took a bet it couldn't cover if the horse won, it
off-loaded the risk to other bookies by betting a proportion of the punter's
money on the same horse with them. If the horse lost, all the bookies made
money; if it won, the losses were 'spread' and thus manageable. Call it
My boss suspected that the runner wasn't laying off the
money with other bookies - he was gambling that the horse would lose and he
could pocket the money. If it won, of course, my boss would be exposed and
probably out of business. Such a business-critical activity was, therefore,
Kerviel decided not to hedge his bets. The markets
turned, and his actions might eventually mean the sale of SocGen. Some years
ago I wrote that the financial market was the biggest casino in the world. It
seems that I was traducing casinos; they appear to be better regulated and