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Author Captain Prozac     View Profile     Add to favourites     Ignore
Date posted 2009-12-22 22:49
Subject Article from Asia Times 
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Dec 23, 2009
Bank on little change
By Martin Hutchinson

It must surely have become obvious from both the catastrophes of 2008 and the bumper profits of 2009 that the investment banking/trading business, whether through independent behemoths or within even larger commercial banks, simply isn't working.

Now that "too big to fail" bailouts by taxpayers have been established, risk management in the industry is a joke. Thus the Basel Committee on Banking Supervision's recommendation last week that banks suffering capital shortfalls should be forced to stop paying bonuses is a welcome opening salvo in a new struggle. That struggle is to force investment bankers' remuneration back towards a partnership system. Investment bankers must suffer in their pocketbooks from disasters, and rent-seeking rip-offs of the taxpayers and the general economy must be minimized.

The Basel Committee's proposal met with predictable outrage from the investment banking industry, although its other proposal to ban dividends if capital fell too low was predictably well received. The ban on dividends would make sense if shareholders were meaningfully in control of these behemoths, but they're not. Investment banking management, who are actually in control, would happily deprive shareholders of their dividends; after all, under the theories of modern finance, they are mere "providers of capital" - servants of the superior managerial class.

It has now become clear that risk management as practiced by investment banking operations is not merely ineffectual; it is a diversionary fig-leaf. Using it, management can pretend to regulators that risks are being managed. That allows them to leverage to ever-more excessive levels and take ever-more exotic risks through securitization, extreme derivatives and credit default swaps.

Before 2008, there was a certain restraint about this because losses would fall on shareholders, and managers worried that their careers might be destroyed by failure. Now that it is obvious that state bailouts will be available in a disaster and most careers will be safe, the downside risk for investment bank management has been minimized.

After all, except for the poor souls who ran Lehman Brothers, the perpetrators of the 2008 debacle all remain in their jobs and many of them will receive record bonuses in 2009. Even at Lehman, the purchases of most of the operations by Barclays and Nomura kept most of the senior and middle-level investment bankers in their jobs.

Most startlingly, David Viniar, Goldman Sachs' chief financial officer, is still in office. Viniar made the headlines in August 2007, when in response to market developments which compared to those the following year were no more than a hiccup, he referred to "25-standard-deviation moves, several days in a row". Nothing more exposes the spurious folly of Wall Street's risk management methodologies than Viniar's statement, unless it is Goldman Sachs' failure to react to it.

If market risks were Gaussian, as Wall Street risk management models pretend, then 25-standard-deviation days should not happen even once in the entire history of the universe. By his statement, Viniar exposed risk management for the fraud it is - yet as CFO he retains overall responsibility for risk management at Goldman.

Our objective must be to return to a system with reasonable levels of integrity, thereby lowering the exorbitant costs to taxpayers of the current monstrosity. To do so, we must find a way to place the costs of losses primarily on those who cause them.

Traditionally, investment banks and London merchant banks were partnerships, with unlimited liability, in which creditors in a bankruptcy could go after the partners' assets. Being medium-sized institutions, the combined capital contribution of their partners was sufficient to fund their relatively low-risk operations, consisting primarily of advisory and underwriting work, with a modicum of brokerage and principal investment thrown in.

It was recognized that the reputation of the institution was the main driver of its ability to attract business. If a house became known for shady dealing or over-trading, it would find itself losing the semi-tied corporate advisory relationships that were its bread and butter.

With the behemoths at their current size, the partnership structure is not directly re-attainable. In any case, it makes little sense for the commercial banking operations of the universal banks. With deposit insurance, partners' liability is superfluous, and since you don't want only billionaires qualified to run commercial banks, a partnership structure is impossible for the largest institutions. Instead, banks accepting guaranteed deposits should be tightly limited in their activities, with trading operations and proprietary investment operations hived off or shut down.

It is completely inappropriate for taxpayers to guarantee (even through a nominally industry-funded pool) the mistakes of testosterone-crazed traders working off dodgy risk-management metrics. Naturally, once commercial banking has become a low-risk activity its management will be rewarded at levels common in the public sector or in such low-risk operations as electric utilities. There will be no need for it to employ people with skills justifying multimillion-dollar bonuses, and certainly the bureaucrats without those skills chosen to run commercial banks should not be rewarded at multimillion levels.

For trading and brokerage operations, or for any possible "high-risk" banks choosing not to accept guaranteed retail deposits, the Basel proposal then makes sense. Such operations, if properly capitalized initially, will normally only fall below the Basel precautionary level (set at 25% above the regulatory minimum) through losses on their loan or securities portfolios. In those cases, depriving management and traders of their bonuses is entirely appropriate. To the extent houses subject to such sanctions lost star traders, it would reduce the scale of their businesses appropriately, rendering them better capitalized in relation to their remaining risk level.

Of course, if banks were subject to this kind of sanction, their traders would tend to take less risk, and their management would be very careful to set trading limits that prevented traders from endangering their own bonuses. Incentives would thus be set properly, in that all participants in the firm would be driven to manage risk responsibly, and not engage in excessively risky trading or excessive leverage that endangered everybody's returns.
This proposal would be especially beneficial in reducing the current incentives toward designing and trading exotic derivatives and other products, which appear at most times to have only moderate risk but where risks are heavily concentrated in the "tails", emerging to devastate the balance sheet at times of market stress. If managers and traders knew that heavy indulgence in credit default swaps, for example, would very probably result in major losses to their own pockets, they would be much more cautious in resorting to these toxic products.

The Basel Committee's recommendations will not solve all the problems relating to modern investment banking. For one thing, they will not significantly limit the rent-seeking that comes from insider trading through "fast trading" mechanisms in which computers located at the stock exchange take advantage of inside knowledge of money flows. Nor will they reduce much the trading orientation that has resulted in the advisory and new issue businesses, the true economic value of investment banking, becoming afterthoughts in the institutions' overall profit picture.

However, if they make it unattractive for top advisory specialists to work at trading-oriented behemoths, the Basel Committee's proposed bonus restrictions may contribute to market cleansing here, too.

"Boutique" investment banks, mostly established since 2000, are gradually taking an increasing share of the advisory business. The great Lord Cromer, governor of the Bank of England in the 1960s, once described the principal market advantage of the old London merchant banks as "prestige and standing". (It certainly wasn't size or capital.) If the boutiques get the best advisors, and start to do the most important deals, prestige and standing will accrue naturally to them, and the behemoths will become relegated to the position of dinosaurs, fated for eventual well-merited extinction.

The Basel Committee has a lot of catching up to do. Its ill-fated "Basel II" standards made the appalling mistake of legitimizing the phony "value at risk" risk-management system. Those standards also discriminated in favor of the largest banks, allowing them essentially to regulate their own capital levels while medium-sized and smaller banks were more restricted. The Basel Committee thus bears a substantial portion of the responsibility for 2008's debacle and the immense losses to the public which that caused. However, its latest proposals on banker bonuses point in the right direction, and may begin to make some atonement for the committee's past misdeeds.

What's the betting that, following industry consultation, the Basel bonus proposals disappear well before the final regulatory draft, never to be seen again?

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