Evolution of Banking and Finance


Correlated systemic risk increase

Urgent need of a stringent control

Of the news activities of Banks

And Financial Institutions

Analysis and proposals

By Didier E. Bertin – 15 November 2010



This English version is the reference version; the former French version was made for indicative purpose.

La version anglaise est la version de référence et la précédente version française n’avait qu’un rôle indicatif.


The comments and suggestions that follow are mainly based on personal experience of the market since the seventies.




The crises related to new products are obviously related to a basis maladministration of Banks having generated many collapses in the past and more recently in Ireland. The problem is ultimately the competence of the cast selected to manage the banking system.


I - A first significant step

A new market: the Euromarket

In the late sixties and early seventies, the main banking market understood the potential benefit from huge amounts of dollars hold by non US residents arising from U.S. funding abroad, or dollars accumulated by USSR and oil suppliers utilized as new source of investment funding. Initially, banks choose to penetrate this terra incognita as group of scouts such as consortia and quickly took the direct control of this new market. Though dollar remained the major euro-currency, other currencies were also utilized.  These resources were available on short term basis and their conversion into stable funding was commanded for long term applications. Such stabilization was the mission of trading desks, which increased the transparency of their availability on the whole market by way of vast interbank activities. Trading helped then substantially, the mastering of these new asymmetric tridimensional new resources in term of periods, interest and exchange rates.


II-Research of applications for these new resources:

Changing the approach of risk


The risks taken by the trading desks have drifted them away from the traditional banking orthodoxy in particular in the field of risk up to the extent that banking and finance institutions took progressively the appearance of a two-headed animal.


The virtues granted at that time to sovereign risk often seen as a quasi non-risk has represented a substantial part of the allocation of the new subsequent resources. It was generally considered that a state may hardly bankrupt as a result of international alliances and of the absolute need for USA and USSR to maintain a necessary worldwide political balance to escape major frontal conflicts.


 "This was not more than an act of religious faith from Banks” to allow them to get away from the painful work of responsible risk analyses; this permitted to deal with high volume of money in order to compensate reduced margins due to unquestionable sovereign risk and by the same token produce substantial profits in value. The many countries that were developing or consolidating their development opened up broad prospects of easy profits for Banks, from Asia to Latin America via Africa and also including paradoxically the eastern countries. The intellectual paradox was the opposition between capitalistic funding and communist beneficiaries. However intellectuality is generally alien to Bankers.

In this new conception of simplified risk, Banks preferred among developing countries dictatorships supposed to ensure social order and work more efficiently than democracies; the Soviet bloc that included dictatorships obtained was favorably viewed by Banks impressed by its force demonstrations. Bankers were even not asking from them any serious economic information as requested from other countries. We often heard as consolation for them that economic data would have been built anyway on a Marxist conception impossible to understand.


 The collapse of emerging countries and the inexcusable victories of peoples over dictatorships from the perspective of Banks have ruined their dreams of easy money.

We must also notice that this new attitude of Banks consecrated their divorce with their Saint Simonian’s vocation of main of their founders who wanted to be partners of industrial companies to ensure common development.


III-A second significant step: The invasive virtuality

Many activities and reduced real benefits for the global economy


Chicago with the CME (Chicago Mercantile Exchange) and CBOT (Chicago Board of Trade) was the first market where farmers were able to protect them with hedging against changes in foodstuffs future variations of prices in particular for climatic reasons. From a specific need of agriculture, the first derivatives were extended in many other areas and places.

It is now necessary to differentiate between products that have real utility for economic development and those that serve only speculation with no other purpose. Products useful to the real economy are those that relate to exchange and interest rates used by industrial firms for foreign trade and capital goods acquisition.

In the field of virtual product derivatives have been followed by structured products, whose common feature is the application of techniques producing virtual multiplication of a reality whose uniqueness is stubborn,  in order to increase service proceeds.

To overcome the constraints of reality, funded structured products is a way to multiply the effect of the same reality for Corporate, while for trading desks, derived products which are

mostly unfunded multiply operations issued of flows of opinions also based on a very distant reality; changes in Stocks indices or interest or exchange rates are  based on groups of opinions regarding the fate of a particular risk  linked to companies(e.g. case of CDS-Credit Default Swap), currencies or interest rates. Stock Indices may even have a perverse effect on reality by underlying immediate effects steps on profit far from long term lasting policy regarding same profit.


1-Virtuality for the "Corporate": some examples


Example 1

After the drying up of sovereign opportunities, the new target of numerous banks in quest of easy profits was healthy companies with low leverage. Banks decided to convince number of such companies to increase their leverage by simply changing their shareholders and firing their managers.


It was just sufficient to buy back their stocks at high price if necessary trough a heavy indebted vehicles and then merge them the target-company and then transform the healthy company into an over-indebted company obliged to pay Banks heavy interests after having replaced the former managers.


The payment of interest was not only a hold-up but it also affect seriously the investment capacity of the target company which might become then unable to renew its productive assets when necessary impairing  by the same token the jobs of workers. The reduction in profitability is the remuneration of the Bank.

In fact more dramatic effect occurred because new interest reduced cash flow into the extent that the target-companies were often not able to repay their new debt.

The repayment of debt involved the sale of part of all of the assets of the company and often the best ones. The company then lost a main part of its industrial substance or bankrupt following the former delinquent action.

This type of operation is an LBO (leveraged buyout) that is to say a takeover by means of borrowed capital.

Example 2

Companies are not good enough to directly borrow money, they do not necessarily need , on the financial market; In order to overcome this hurdle; we may simply transform  them synthetically in good enough companies.


We create a vehicle that will collect the best company assets (property, stocks, claims ...), and thus we obtain a very good entity by siphoning. The new good vehicle will secure in the limit of its new creditworthiness, the bonds issued by the siphoned company.


The bonds will therefore rank better than those that the initial company could have issued. This system is feasible in the context of a securitization; it does not change reality, but allows a real increase of indebtedness of the Company only beneficiary for the financial market.


Assets that improve the operation are only virtually moved (by contract) and in case of default of the bond issuer, the assets of the securing vehicle, which are in fact those of the company in default, may simply not be usable anymore.

2-Virtuality for trading desks

The Corporate includes a growing number of structured financings that leads it away from the industrial reality, which remains nevertheless its baseline and this is not the case of most operations of the trading desks.


For example, indices reflect the current opinions on the possible performance of a company and we may even engineer, using derivatives, a second stream of opinions based on the first stream of opinions (this could be repeated endlessly) and thus be in a speculative universe increasingly autonomous from reality up to the point of influencing as a boomerang effect the initial reality instead of aiming to reflect it.

This market and aspects and collateral risks will be viewed in more detail in Section VI.

3-Status of major banks in Europe




NBP* %

Net Interest





















* Net Banking Proceeds 2006

Loans proceeds tend to become substantially under half of Net Banking Proceeds because of the increasing share of trading activities (negotiation) and services (fees, etc.). Even the loans activity no longer corresponds to a conventional business of investment for the traditional economy and employment but is due to a large extent, to structured financing, which reorganize the industrial assets without increasing them.


In its 2007 report, “La Commission Bancaire”, the French Banking control authority, made the following comment:




4-The problem of operations based on net worth resources (Shareholders ‘Equity)


In an entity, financial flows between resources and applications are a whole and the distinctions that tend to allocate certain resources to certain applications are only made for management convenience and sometimes are due to contractual links with negligible funding interest.


This is the rationality basis of structure ratios.   By these ratios we check that for all applications, the net worth represents a certain proportion of their resources as a whole, as a kind of security margin.


Despite this evidence, Banks including the biggest pretend that they may run high risks on the counter value of net worth, in order to increase the net worth return. Their top managers stupidly pretend that operations on net worth may have no adverse effects on third party resources but risks on net worth have of course effects on the whole balance sheet.  

IV- Potential or actual Factors of systemic Risks and Crises


A crisis is systemic when it extends to several market players and markets by contamination.
Example 1






The crises of various markets reached up to 1998, have affected the entities including substantial speculative risks and particularly the hedge funds and by far the biggest of them LTCM (Long Term Capital Management). The highly speculative positions of hedge funds and in particular of LTCM had caused a systemic crisis in 1998.


 We must note that the risk associated with hedge funds was just before the crisis reviewed by the Basel Committee (whose task was the risk reduction of Banks and the improvement of its measurement) just before the crisis and show the restricted utility of such authority, which are too often the firemen coming after the fire.

LTCM hold 1.2 trillion dollars of speculative positions. Many Financial Institutions held hedge funds shares and in particular those of LTCM and then financial market and hence the whole economy was close of collapsing.

Pressures were exerted on Banks in order that they recapitalize by all possible means the hedge funds to avoid chain of bankruptcies. The recapitalization was of course made with the public resources i.e. by the money of citizens which appear to be at high risk in the hands of Bankers who appear to be in fact adventurers and gamblers.

This major crisis was particularly expensive for the world and originated by the initiative of an individual, John Meriwether founder of LTCM. John Meriwether was left free to continue his harmful activity up to now and he has recently created another hedge fund heavily committed with operations related to subprimes.

Example 2

Despite the 1998 crisis, hedge funds have in fact continued to promote a speculative and harmful activity. In 2008, hedge funds, which were not forbidden despite the crisis of 1998  have stupidly accumulated large volumes of transactions based on subprimes because of their high yield and without taking into account that such yield was linked to high risk apparently always in their quest for easy money.


The subprimes are in general junk credits granted to fragile debtors but were mainly in this case mortgage loans granted to fragile and ill-advised borrowers, who were even not covered against the risk of interest rate changes; this was done by bankers to maximize their borrowing capacity when rates were low.


The interest rate rise have produced the numerous failures of these borrowers and the fall value of subprimes value  and then the fall of products related to subprimes used as collateral for securitization such as collateralized debt obligations ,CDOs  and Asset-Backed Securities, ABS.  500 billion dollars of provisions were recorded as a result of the fall in values of ABS and CDOs linked to subprimes, jeopardizing once again the international financial system.


Example 3

In 1995, Nick Leeson, a trader at Barings Bank took at its own initiative huge open positions and their unwinding shook the Japanese market and involved the Bankruptcy of Barings Bank.

The positions amounted to 27 billion dollars out of which 7 billion on Japanese stocks and 20 billion in interest rate instruments linked to Nikkei. He simply had the personal opinion that the Nikkei will increase up and bring down the interest rates. The imperfection of the Bank system may then give a simple gambler and adventurer, the capacity to take risk of size shaking two big nations.


The discovery of the fraud was made possible thanks to the intervention of the unorganized earthquake of Kobe.

Example 4
In 2008, and despite the lessons that should have been drawn from Barings Bank’s case, it appears that Jerome Kerviel, a trader at Bank Société Générale took again at his own initiative and without authorizations open positions of 50 billion Euros quite similarly to Nick Leeson but for a much bigger amount


The most disturbing is that at bank Société Générale does not appear to have “basically” control methods really worse than other banks but frauds have nevertheless spread over three years.


As for Barings Bank, frauds have been identified by total fortuity simply because a structure ratio had to be calculated when the trader lodged exceptionally and for a period of few days his fraudulent operations in the book of a trader with no granted limits.


Société Générale is the second largest bank in France and the eighth Bank of the world; a possible bankruptcy could have had systemic consequences of a magnitude difficult to assess without the proper intervention of fortuity; these positions could have continued to grow and the related risk is only measurable at the time of unwinding. An open position of 50 billion was taken in only 2 days, on 2 and 3 January 2008.


The real problem is not the trader but the system which enabled him to initiate alone a major systemic risk, which might have impair the financial market end then the global economy. Moreover the control system, which knew some dysfunctions, seems globally quite similar to those of many other Banks.

V-Banking and Finance Market:
 Systemic risk linked to entity’s risk

The Wholesale Banking business must associate low yields insufficient for risks remuneration with large amount of commitments i.e. risks in order to achieve the targeted high level of profits in value on in return on equity. Large volumes induce intense interbank activity including exchange and sharing of risks with a concomitant high level of systemic contamination. Paradoxically, and in order to achieve the profit targets , the more the risk remuneration decreases, the more Banks take larger volume of risks  and consequently amplify substantially the world systemic risk.


The combined quest for increasing profits under market pressure led to a structural increasing weakness of the world finance system and significant  signals were sent by the lot of LTCM and Lehman Brothers.

VI - Speculation and Control

This aspect will be viewed through the case of Société Générale


1-The Facts

For 3 years, Société Générale’s accounts were inflated by unauthorized speculative positions taken at the initiative of a trader .Société Générale did not notice anything despite the size of the amounts which increased to the equivalent of twice of the value of its shareholders ‘Equity. These transactions amounted to 30 billion Euros in 2007 to increase to 50 billion Euros in January 2008, well beyond the record set by Nick Leeson.

The motivation of this trader was to build sustainable profits, very high but within normal activity of an excellent trader in spreading them when necessary over future fiscal years. The idea was to build for himself a reputation  of a money-winner especially popular in trading desks as well at the highest level of the Bank staff and of course to maximize the amount of his bonuses while ensuring them regularity .


We should not exclude the fact that this very young trader lost the sense of money amounts on trading desk and this raises the question to change regularly the activity of each employee within a Bank for security reason and to fight the unfortunate spirit of trading desk and in particular regarding bonuses.

With only 7 years of professional experience, this junior trader in 2005 expected to receive in 2008 for a relatively simple work a bonus of around 600 000 Euros according to its own calculations which is equivalent to  600 net minimum French wages,  which is a serious inequity in relation to all other employees.

The fraudulent activity was based on the trading of derivative products with underlying stock indices as DAX, FTSE (named Footsie) and Euro Stoxx 50. The accumulated risk of 50 billion Euros in January 2008 was based on Euro Stoxx 50 for one third and on DAX for the balance.


DAX is based on the quotations of the stocks of the 30 largest German companies and cover 70% of the capitalization of trading market in Frankfurt.
Euro Stoxx 50 is calculated on the basis of the 50 best companies in the Euro area. This index is used as underlying of structured products and derivatives.
FTSE (Footsie) is based on the stocks of the 100 largest companies listed in London by market capitalization.


Creating new instruments of speculation based on speculation indices, paves the way for speculation on speculation and the border with the game world becomes blurred.


It should be noted in this sense that this trader who had taken the initiative of a 50 billion Euros risk was a regular client of “clairvoyance” services according to the police investigations.

2-Internal control and auditors

The entire control organization of Société Générale, which seems to be very close to those of other large banks, has not been able to discover positions having reached 50 billion Euros without the assistance of fortuity.


One should also note that the system of Société Générale check only the “net positions” (risk reduced by security) and not the overall risks and thus creating a false security permit to dissimulate risk of any size.


The common sense leads us to think that nevertheless a risk is composed the position run and also of the risk inherent to its assumed correlated security. This basic common sense was missing in Société Générale as it could be the case of many other Banks. This type of laxity is unbelievable in institution wasting to often time in useless details.


Unauthorized operations were not seen by all levels of hierarchy as well by all levels of operations implementations and control units such as:

-Front Office,

-Middle Office,

-Back Office and

-Compliance department

- Internal auditors

-External auditors of famous companies


The accounts of the Banks were duly certified without any qualification.


The discovery of these fraudulent actions were totally due fortuity and without it, their discovery could have been disclosed by a possible bankruptcy of the Bank for an amount of loss not calculable before unwinding positions.

The greed for return on equity for the benefit of the market attitude and for bonuses at all levels of the Bank's management may also be probably a major reason for this behavioral dysfunction combined with maladministration as this is illustrated by the following situation:


The limit applicable to the trader and his department was 75 million Euros. This limit was most of the time not respected and in a normal situation the hierarchy should have reminded severely the need to remain under the limit. Instead and in order to please the traders, the hierarchy increased the limit by 66% to 125 million Euros.


Naturally, the new limit of $ 125 million was no more respected than the former limit of 75 million Euros.  Increasing limit instead of complying with it is as much stupid as disconnecting a fire alarm to prevent fire.

An inspector from the Banking of Commission Bancaire said that the trader fraud techniques were not particularly sophisticated and not unstoppable and that his actions could have discovered earlier. Commission Bancaire accused Société Générale of insufficient controls and imposed a penalty of 4 million.

One can also note that all type of uncontrolled may be easily lodged in the provisional registration accounting system of Société Générale and the high number of provisional operation did not enable the Bank to have this system under control.


On top the computerized automatic control of the trader was “unfortunately” not activated.


The Court decided that the unauthorized positions were not identifiable, given the large number of transactions the trader (500 000 operations) and the further discovery of frauds had requested a workforce from 800 to 1000 man-day.


We understand the Court position which seems to reduce in appearance of the responsibility of Société Générale and retain the sole responsibility of the trader, but in this case we may conclude that the Court questioned the ability of all Banks to control their trading desk activities, at least with respect of speculation products.




The crises related to new products are obviously related to a basis maladministration of Banks having generated many collapses in the past and more recently in Ireland. The problem is ultimately the competence of the cast selected to manage the banking system.

The quest of easy money without specific consideration for the overall economy has too often led banks to abandon a rational approach to risk assessment and replaced it by dangerous and oversimplified shortcuts.

Too often, the risk analysis takes the form of an act of quasi religious faith as it appeared for example for sovereign risk sometimes cynically oriented, but for some other risks thereafter.

The drying up of opportunities in sovereign risk led the Banks to play sorcerer's apprentices by trying nothing less, than multiplying the uniqueness of reality through structured products.


Such smoke and mirror have temporarily improved bank profits, but too often have adverse effect in fine on genetic reality and in any case have brought nothing to our nations needing urgently tangible economic expansion and real employments for people, except few fees, commissions and bonuses for Banks.

Similarly derivatives have multiplied the opportunities by way of increasing speculation based on same unique reality to the extent to produce speculation on speculation as a simple dilatation physical process.


These dilatation techniques on a reality in contraction produce additional gain for Bank by inadequate and badly oriented transfers and without creation of new richness for real economy and employment with a few exceptions for foreign trade and capital goods funding.


The Bank did not act as good citizens of course but utilize means endangering the whole financial system and global economy, which command stringent steps from the State in charge of the security of their citizens and because citizens cannot continue to rescue with their own funds private or through nations, adventurers and gamblers.


Banks maladministration have reached a climax by enabling individuals to create systemic crises and this is no more acceptable even if the legal responsibility is clearly on them but their feasibility is clearly on system.  When the system collapses the stricto sensu legal responsibility of few individuals is useless.


The citizens should create alternate and responsible institutions to collect their savings ideally but the importance of current crisis does not permit to have sufficient time to recreate a new financial system and thus we should reform the existing one at least for European Union.



It is urgent in our view, to take the following steps:

1-Restriction the activity of the Bank to the support of real economic development and in particular Industry and sources of employment

2-Limitation of the structured products and derivatives with few exceptions duly justified by economic needs such as external trade and capital goods -


3-Ensuring that risks are not taken for an amount equivalent to the Shareholders ‘Equity in order to restore the value and meaning to the ratios of structure

4-Elimination of  all privileges of trading desks, which must return to the orthodox banking culture of risk in line with the understanding of the real world of economy and implementing of staff turnover


5-Stop of gambling atmosphere in trading desks

6-End of rewards disproportionate to the global wage and which can lead both to delinquent behaviors and adverse decisions for the long-term interest of the companies

7-Ensuring that wages are a real payment of work and bonuses are only a minor part of global wage

8-Creation of new audit companies to replace some of the traditional Anglo-Saxon companies that have too often certified unreliable financial statements

9-Creation of a European rating agency under control of the European Union, which would ensure a serious risk assessment according to rational criteria and establish a rating based on long term prospects in order to clean the market of too many irrelevant agencies

10-Organization of a permanent presence of the State with a veto right, in the boards of directors of all European banks for the sake of good public order.


11-Obligation of transmission of information by the employees to a state agency in case of possible doubtful and dangerous actions from Banks as this is already done regarding money laundering.









On the contrary an equivalent amount of net worth should be left free of any risk to justify the logic of structure ratios that reflect a safety margin for all applications.

 "... The corporate activity has been strong, partly due to the development of mergers and acquisitions, leveraged buy-out (LBO) and structured finances. Trading operations on financial markets have experienced a very strong growth in almost all groups ..."