THE BEAR'S LAIR
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
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
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
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
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2009 David W Tice & Associates.)