Risk - SINCLAIR STEWART

In the fall of 1752, a seasoned captain by the name of Henry Kent boarded the Dragon, a 310-ton merchant vessel, and set sail from the southern coast of England, bound for Bengal.

During his previous 14 years in the employ of the East India Co., both as a mate and a commander, Kent had amassed a remarkable record for punctuality: Despite the great distance of this trading route, and the perils of pirates, disease and weather, the sailor always returned to his home port on time.

But on this, his final trip, Kent veered into uncharted waters. Although he rounded the Cape of Good Hope in early 1753, squarely on schedule, he did not continue on to Bengal. Instead, he spent four months on the coast of Madagascar, cutting side-deals with the local population for his own benefit, helping to build a factory, bartering alcohol, and even buying slaves.

This sojourn caused him to miss the seasonal window for a return passage to England, conveniently enabling him to extend his extracurricular business pursuits (and no doubt imposing significant costs on his employer, the East India Co.).

Kent may prove to be among the first rogue traders of the global economy, a swashbuckling precursor to the likes of Nick Leeson, who sank the British bank Barings in 1995, and, more recently, Jérôme Kerviel, the 31-year-old Frenchman whose allegedly unauthorized trading cost Société Générale about $7.2 billion in losses this year. Like these latter-day renegades, Kent used the resources of a powerful and well-capitalized company to engage in improper trades; and, like them, he incurred considerable risk when he did so.

"The mortality rate was 60% on these ships, and people were dying like crazy," explains Emily Erikson, a professor at the University of Massachusetts who chronicled Kent's travels in a paper she co-wrote with Peter Bearman of Columbia University. "There had to be some sort of compensation, and that was engaging in this illicit activity."

Risk taking has been part of human culture since the prehistoric era, whether it be hunting big game or rolling a primitive form of dice known as knucklebones.

Yet rarely has the subject occupied such a central place in the collective consciousness. The U.S. economy is teetering on the brink of recession and threatening to pull other countries down along with it. Investors have lost faith in some of the world's most storied banks, whose reckless promotion of exotic derivatives products fuelled an ill-advised boom--and resultant collapse--in the subprime mortgage industry, leading to hundreds of billions of dollars worth of losses and the savaging of the credit and equities markets.

And then, of course, there are the alleged escapades of Kerviel, the rogue trader who improbably hoodwinked one of Europe's largest banks and, in the process, became an overnight poster boy for a global banking culture drunk on risk.

Kerviel came from modest means (his mother was a hairdresser; his father taught metalworking), and attended a middle-of-the-road university. The French banking system is known for its class-consciousness, and it rewarded Kerviel's unassuming pedigree with a correspondingly unassuming job: He was sequestered far from the limelight of the trading floor, performing administrative work.

Eventually, he was promoted to junior trader on the "Delta One" team and specialized in European stock index futures--the trading equivalent of giving kids plastic cutlery so they can't hurt themselves.

Kerviel was supposed to be looking for arbitrage opportunities--discrepancies between index futures and underlying cash prices that might yield a small profit. Instead, he began making a series of escalating bets on the direction of these markets, and used his knowledge of the back room to evade his superiors, creating fictitious offsetting trades. These offsets made it look as though he had removed himself from a position, when in fact he was accumulating a portfolio worth billions. It worked swimmingly until early this year, when the market suddenly turned, forcing him to backtrack in an even more audacious fashion. By the time the bank learned of his alleged duplicity and took action to unwind his trades, it was staring into the maw of a $7-billion loss. It was by far the most devastating account of rogue trading in history, and perhaps the most unusual.

What sets Kerviel apart from his predecessors is his apparent lack of motive. Unlike, say, Captain Kent and Leeson, he didn't seem to be making the unauthorized trades in order to feather his own nest. In fact, he suggested to prosecutors that he just wanted to be recognized within the firm and perhaps bag a bonus of a few hundred thousand dollars--chump change by the heady standards of investment banking.

That raises some interesting questions, not merely about lax supervision at SocGen, but about the very genesis of risk taking in the financial community.

It has typically been assumed that self-enrichment is the catalyst for this behaviour. But as Kerviel's example suggests, maybe there are other, less discernible, motives at work. What if his propensity for risk is genetically hard-wired? What if he just wanted to belong? What if, as he has intimated, the very culture of banking was complicit in his misdeeds?

The study of risk, like many disciplines, has tended to fracture along academic fault lines, with neurologists, psychologists, sociologists, evolutionary biologists and, most recently, geneticists weighing in on why we engage in this sort of behaviour.

"As I see it, there is not a single human act with total certainty of outcome. Ergo, all behaviour is risk-taking behaviour," says Gerald Wilde, a professor emeritus of psychology at Queen's University in Kingston, Ontario. "The art of life isn't the art of minimizing risk--the art of life and of decision-making is the art of maximizing risk. One has to venture, but the question is, how much to venture?" In other words, what compels one person to drive at reckless speeds or sky-dive, or risk a prison sentence for illegal trading, while another steers away from the shoals?

There is mounting evidence that some of these tendencies have a strong genetic component.

Geneticists have long suspected that, in centuries past, men who were successful hunters and warriors were perceived as better mates, and were therefore likely in a better position to pass along their genes--assuming their heightened willingness to take risks didn't get them killed first.

But it wasn't until the 1970s, when noted psychologist Marvin Zuckerman conducted tests on twins, that more quantifiable evidence began to emerge. His study led him to conclude that about 60% of sensation seeking--a personality trait closely linked to risk taking--is genetically determined.

"Risk is a subjective thing. Very few people actually know the risk of something they undertake," says Zuckerman, a professor emeritus from the University of Delaware. "Impulsive sensation seeking tends to be linked to a tendency to act without planning ahead, which can also be a characteristic linked with sensation seekers in the financial world."

Zuckerman points out that high-sensation seekers tend to have low levels of monoamine oxidase type B, or MAO-B, an enzyme that helps break down and regulate dopamine. Dopamine receptors have been linked directly to our thresholds for sensation seeking, and the implication is that without sufficient MAO-B to keep our urges in check, people could be prone to risky behaviour.

Not surprisingly, women have higher natural levels of MAO-B than men, and the amount we have in our bodies increases with age, mirroring our tendencies to become more conservative and risk-averse as we get older.

More recent studies have focused on stathmin, a gene that plays a key role in the way we respond to fear. In 2005, a research team bred mice that had no stathmin and then placed them in a large box. Whereas normal mice instinctively scurry to the safety of a corner or wall, the genetically modified mice would often linger in the open space, seemingly oblivious to what should naturally be, at least for them, a fearful situation. In turn, that reduction in fearfulness prompted them to take the additional risk of remaining in a vulnerable position. "When there is a lack of fear, it can modify behaviour," explains Gleb Shumyatsky, the Rutgers professor who led the research effort. "Here, this deficiency in fear leads to improper risk assessment."

Risk taking, however, can't simply be boiled down to genetic determinism, any more than Kerviel's rogue trading can be solely attributed to low MAO-B levels or a stathmin deficiency. While genes influence personality traits, so too do myriad other circumstances, from diet to childhood experiences to one's physical environment and emotional makeup.

Indeed, one study published this year has determined--much to the chagrin of some classically trained economists--that our emotional state greatly influences the way we make supposedly rational financial decisions. The research was conducted by two experts in neurofinance, an emerging discipline that seeks to understand trading and investment behaviour through the lens of neuroscience.

Camelia Kuhnen, a finance professor at Northwestern University, and Brian Knutson, a psychology professor at Stanford University, triggered heightened emotional responses in men by showing them erotic material, and then measured their brain activity. Next, they presented the men with two gambling options, one of which involved taking on more risk. As their arousal increased, so did their propensity to opt for the riskier bet.

"The message of our work is the fact that emotions determine very high-level decisions, like your portfolio, and investors should be aware of this fact," says Kuhnen. "If I may speculate, money has become what psychologists call a primary reinforcer. The sight of a $100 bill and a platter full of hot lasagna when you're hungry--they do the same thing to your brain. Money is now, in an evolutionary sense, comparable to any other sort of primitive reward, like food."

Yet that still doesn't explain why people who are already incredibly rich continue to incur serious risks in the hope of making more money. Nor does it account for why someone like Kerviel would risk public humiliation and jail time seemingly without the possibility of gleaning much in the way of financial reward.

Addiction specialists don't see much difference between a rogue trader losing billions of dollars and a compulsive gambler sinking into debt at a casino: Both can be addicted to the adrenalin rush of winning, and both can be prone to doubling down repeatedly in an effort to reclaim their losses. "The pattern tends to be people who have some pretty high expectations of themselves and who have had some success," says Nina Littman-Sharp, who manages the problem gambling services unit of the Centre for Addiction and Mental Health in Toronto. "People get very hooked by an early win, particularly if things aren't going well for them otherwise."

Kerviel himself, in discussions with prosecutors, seemed to acknowledge he had a similar problem. By December, 2007, he was actually sitting on an estimated $2-billion profit realized through his unauthorized trades. That was just before the market turned against him, converting those profits into billions in losses and sending him into a spiral of more fake trades to hide his mistakes. "I didn't know how to deal with it. I was happy and proud of myself, but I didn't know how to justify it," he said in a transcript released by French authorities. "Thus I decided not to declare it, and to hide the sum, I created an opposite fictional operation."

As for his decision to engage in this activity in the first place, he only hinted at a motivation. He was a middle-class outsider who lacked the social and educational credentials of his peers in the banking community; as armchair sociologists pointed out in the aftermath of the scandal, he may have taken on such outsized risk to earn respect and prove himself an equal. "I was aware, starting from my first meeting in 2005, that I was less well-considered than the others, as regarded my university degree and my professional and personal background," Kerviel told prosecutors. "I had not come directly to the front office, but had passed through the middle office, and I was the only [trader] to have done that."

Kerviel surrendered himself to police in January, and spent five weeks in jail while his lawyers negotiated his release on bail. He has been charged with forgery and breach of trust, and a trial is expected to begin next year.

Although he has not denied making the trades, he has remained unusually defiant, implicating the company in his scheme. To his way of thinking, the bank's silence while he was making unauthorized trades, its refusal to question his unwillingness to take vacation, and the regular alerts it issued to him for exceeding his trading limits, was a form of passive acceptance. The pursuit of profit, in his mind, begat willful blindness.

SocGen has vehemently denied this, of course. But some risk experts believe Kerviel might be onto something: that the financial community doesn't just have a problem managing risk (as has been clearly evidenced both by l'affaire Kerviel and the banking sector's disastrous foray into subprime mortgages); it actively encourages the wrong kind of risk.

"I'd argue that there's good risk taking and bad risk taking, and Wall Street is not good at drawing a line between the two," says Aswath Damodaran, a professor of finance at New York University and author of Strategic Risk Taking. "Investment banks are manic-depressive when it comes to taking risks. People are encouraged to take the wrong types of risks for the wrong types of reasons."

There are several fundamental flaws, according to Damodaran, the biggest of which is Wall Street's compensation packages. Salaries and bonuses are based on the ability to generate fees from advising on deals, creating new products or trading; that, in turn, creates an incentive to push these products and deals through the system, regardless of whether they are likely to be good for investors.

Look no further than the subprime collapse, in which banks were pumping out collateralized debt obligations and other complex derivatives that made mortgages more readily available to borrowers with sketchy credit histories.

These derivatives may have been a boon to the bankers who were selling the products, but they proved to have a calamitous effect on homebuyers and credit markets, as well as on investors in the banks themselves.

Some of the world's largest financial institutions have already written off hundreds of billions of dollars worth of subprime exposure, and one, Bear Stearns, collapsed in a broken heap. True, some executives have lost their jobs over the mess and have seen their shareholdings tumble in value, but they've nevertheless exited with handsome--or, to many, galling--severance packages. Stan O'Neal exited the CEO chair at Merrill Lynch with about $161 million (U.S.) last October, after the firm reported billions of dollars in subprime-related losses. Chuck Prince, who resigned as head of Citigroup amid similar writedowns in November, left with $68 million (U.S.).

"It sets up a compensation system where you get rewarded for upside risk but not penalized as much for downside risk," says Damodaran. "We're seeing the risk we're seeing because of the asymmetry of payoffs that are created. This system is designed for strange people, weird people, people almost on the edge, who can take you to the cleaners."

There is also what's known as a "selection bias" in Wall Street's hiring practices that has nurtured this environment of risk taking, Damodaran believes. The MBA students recruited by investment banks tend to be good salespeople with a natural inclination toward taking risks and thereby generating revenue; the ones who have the hardest times getting jobs at these banks, he says, tend to be more thoughtful and cautious.

Virtually every function of a bank, at its core, involves assessing and managing risk, whether it be approving a loan or deciding where to invest deposits. Most investment banks have large compliance and risk departments that are charged with monitoring trading, policing conflicts of interest, and determining the thresholds for acceptable risk.

Yet, on balance, these systems have proved to be woefully incompetent.

Few can figure out how a low-level employee like Kerviel was able to take such massive positions without arousing suspicion among risk experts in the bank. And few can figure out why top executives at Wall Street's most sophisticated firms--and some Canadian ones, too, like CIBC--were seemingly ignorant of the fact they were strapping on billions of dollars worth of debt backed by risky mortgage securities.

One partial explanation: Risk departments have been neutered in the froth of a bull market, their voices afforded less input into decision-making. No one wants to hear someone preach caution when revenue is breaching record levels and creating monster bonuses.

Risk management, it seems, only becomes empowered in the bad times, after disasters have ensued and investors have already been punished. Although banks like Citigroup, SocGen and Merrill Lynch insist they have learned a painful lesson and are upgrading their supervisory structures accordingly, the real test of their mettle will come when markets turn beneficent again. Will hiring practices change? Will risk managers be able to pull the plug on a promising business that could deliver billions in profit--but might also cause potentially grave problems in the future? And will a trader like Kerviel get fired for making huge amounts of money the wrong way, outside of acceptable risk limits? Observers like Damodaran aren't much convinced.

"The people who get the most glory are people who fight battles, even if these are stupid battles," he says, borrowing a page from the evolutionary psychologists. "I'm not sure there's been a huge deviation in human nature over the last millennium, but in financial markets, I think it's become exaggerated. It's at the core of everything we do."