SocGen Fallout; the Brits Get Tough; More

European financial firms can expect a much more unforgiving attitude from regulators following the alleged fraud at French bank Societe Generale, the biggest rogue trading scandal in financial history.

While SG initially blamed its staggering loss on the activities of trader Jérôme Kerviel—whom the bank originally called a “genius of fraud”—evidence is mounting that the bank’s internal control and risk management systems were critically weak.

The bank lost at least $7.15 billion on $73 billion of unhedged futures contracts that Kerviel built up, allegedly in breach of his trading limits and without the banks’ knowledge. Both the French daily Le Monde and the Financial Times have since reported the loss at $9.2 billion.

The French Finance Ministry conducted a preliminary investigation and published a blistering report, which listed eight areas that “could have been instrumental” in SG’s failure to detect the fraud. Among them: concerns about how the bank responded to alarms from Eurex, Europe’s largest derivatives exchange, that Kerviel was making odd deals; the security of bank computer systems and access codes; and how SG monitored the way its traders modified or cancelled their market positions.

Kerviel used to work in SG’s IT department, where he gained detailed knowledge of how certain controls worked and could be subverted. But other weaknesses the Finance Ministry cited related to simple control failings, such as management not spotting Kerviel’s refusal to take any vacation.

In response to the report, SG said the measures that would have let the bank detect and prevent the fraud “have already been implemented, or will be put into place shortly.”

The report said regulators should have more power to punish those who fail to adhere to best practices and warned that other banks could be vulnerable to the same fraud that rocked SG. In response, the French government said it will discuss the idea with counterparts in Europe and elsewhere. “Very clearly some internal control procedures didn’t work,” Finance Minister Christine Lagarde said.

McCreevy

The Finance Ministry report has also prompted the European Union to adopt a noticeably tougher tone. When news of the losses first broke, Charlie McCreevy, the EU’s powerful internal market commissioner, has accused the bank of “abject carelessness” and says Europe should “reinforce the supervision of major cross-border banking groups and financial conglomerates.”

He added that it was “inexcusable” that the bank had “failed to learn the lessons that rogue traders have taught us about the checks, balances, and controls that must be in place for risk to be effectively managed and controlled.”

London Warns Against Compliance Cutbacks

Britain’s Financial Services Authority has warned companies against using a tough economic climate as an excuse to cut back their compliance activities.

In its Financial Risk Outlook report for the year, the FSA says that increased financial pressures could lead financial institutions to pare back compliance with conduct of business requirements (such as FSA rules and principles on fair treatment of customers) and what the agency calls “business-as-usual processes” (such as stress-testing confirmation of credit derivate trades).

“Where firms are faced with financial difficulties, there could be a tendency to concentrate on immediate problems,” the FSA report says. “However, firms must not lose sight of the need to continue to ensure that business-as-usual processes are still handled with due care. This will be particularly important for those tasks which in a crisis may be given lower priority, until the fact that they have not been addressed begins to affect the firm’s performance, or means that the firm is not in compliance with regulatory requirements.”

The regulator warns that financial firms are outsourcing an increasing range of functions, but they cannot outsource responsibility for compliance. “Managers need to satisfy themselves that their in-house and third-party services providers have the appropriate systems, controls, and staff to ensure these risks are robustly managed,” it says.

The report goes on: “Market participants should continue to ensure that operational and compliance areas are sufficiently resourced to cope effectively with business volumes and market volatility. In a more difficult environment, it is vital that firms continue to meet their regulatory requirements.”

Auditors Faulted on Northern Rock Crisis

A U.K. parliamentary committee investigating the crisis at Northern Rock bank has told the audit profession that it must provide better assurance over risk-management practices at banks.

The independent Treasury Committee published a report titled “The Run on the Rock” that examines how the once-successful bank lurched into a credit crunch that led to the worst run on a British bank in 100 years and an emergency $51 billion loan from the government.

The committee criticized the way that the bank had been regulated, but it also said that U.K. accounting bodies should “consider what further assurance auditors should give to shareholders in respect of the risk-management processes of a company.”

The committee also said it was concerned about an apparent conflict of interest at the bank’s auditor, PricewaterhouseCoopers. The firm had statutory audit responsibilities but also received $13.7 million in non-audit fees, mostly for assurance related to the bank’s fundraising activities, the report said.

The Financial Reporting Council, which would be responsible for any action in the auditing industry, seems less than enthusiastic about the committee’s concerns. “Guidelines on auditing internal controls and risk management are outlined in the Combined Code, which applies to all listed companies,” says Jon Grant, executive director of its Auditing Practices Board. “It is a principles-based approach. It was consulted on widely, and it has since been reviewed.”

Grant also says the principles for avoiding auditor conflicts are robust.

FSA Gives Warning on Insider Trading

The FSA has filed criminal charges against two corporate executives over insider trading, yet another sign that the agency is stepping up its attention to such abuses.

The FSA endured bruising criticism last year that it was doing too little to police against insider trading. Officials at the Authority noticeably upped their rhetoric on the topic. Now comes the criminal prosecution, when the FSA historically has relied on civil remedies.

The FSA charged two people with insider dealing offenses under the Criminal Justice Act. The allegations pertain to the use of inside information about a proposed cash bid from Motorola for a company called TTP Communications. One of the accused is the former general counsel of TTP.

Jonathan Marsh, a member of the Futures and Options Association and a partner at the law firm Berwin Leighton Paisner, predicts that the FSA will clamp down on insider dealing by using tactics borrowed from its fight against money laundering.

In the past, the FSA has sanctioned banks for lax money laundering controls, even if there was no suggestion that they had been conduits for dirty money. Likewise, the FSA has the power to discipline executives for failing to do enough to maintain strong insider-trading controls. Marsh warns that regulatory principles in this area are very general, which makes it hard for companies to defend themselves against FSA accusations.