Principal Agent Problem - or what we should now call the Jerome Kerviel Problem

Jerome Kerviel , ex-trader for Société Générale, was found guilty and convicted in what is now history’s biggest rogue trading scandal. Breach of trust, forgery and entering false data into computers all linked to covering huge stock bets, he was sentenced to at least 3 years in prison and must pay his former employer damages of 4.9 billion Euros. That was not a typo.
His illicit stock bets are estimated to have cost France’s 2nd largest bank about 5 billion Euros in losses.

Let’s take a look at a quote from the article in yahoo news;

“Kerviel maintained that the bank and his bosses tolerated his massive risk-taking as long as it made money - a claim the bank strongly denied.”

This is an example of the principal agent problem. The principals (bank) hire an agent (Kerviel) to perform tasks on their behalf but they cannot ensure that the agent performs them in exactly the way the principals would like. The actions and decisions of the agent are impossible or very expensive to monitor and the agent and the principal may have differing incentives.

This lack of information was a costly failure of information and bank office controls and systems. It was reported that Kerviel had taken speculative positions on selected stocks without the knowledge of the bank. Société Générale has already been fined four million Euros after admitting to lax financial controls.

It is also reported that “The bank says Kerviel made bets of up to 50 billion Euros - more than the bank's total market value - on futures contracts on three European equity indices, and that he masked the size of his bets by recording fictitious offsetting transactions.”

The principal agent problem stems in part from a separation of principal from agent, where the agent (trader) acts in their own self-interest, not in support of the aims of the principal (bank), the incentive problem we listed above. Much has been published and written in recent years about the incentives to cheat.

Typically, the incentive to cheat is greatest when given the chance to “play” with other people’s money (no real sense of ownership leads to risk loving). The Kerviel case shows just how risky this can be for huge financial organizations if there is a failure of control over the trading floors.

It was calculated that, based on his current salary of 2 300 Euros a month as a computer consultant, it would take Kerviel 177, 536 years to pay off his damages. Spokeswoman Caroline Guillaumin called the verdict "an important ruling that acknowledges the moral and financial harm done to the bank and its staff."