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Why 'casino banks' need to be reformed

Why 'casino banks' need to be reformed

How excessive derivatives trading turned investment banks into bookies that contribute little to the economy, by Keith J Robertson of Armstrong Financial.

Banking has evolved over centuries to provide two key economic functions for society: the allocation of capital for productive economic purposes; and the provision of liquidity, and reliable lending and borrowing facilities.

Over time these functions bifurcated into retail banking services and merchant banking, what the Americans call investment banking, locating and venturing capital to commerce and industry. Until recently these functions were distinct, the former evolving as regional and then national networks of high street banks, the latter built on the private family fortunes.

There is no need to have moral or rational problems with bankers being well paid if they do a job of economic value and, in the broadest sense, in the public interest.

Providing a safe depository for cash, paying interest and providing capital for the real economy is an economically useful function. Modern societies could not exist or grow without such services. That is what banks have always done and, under the separation of functions that many people want to see, retail banks would continue to do, albeit under tighter regulation and with higher capital ratios.

The ‘casino’ bank problem

The problem lies with what business secretary Vince Cable calls the ‘casino banks’, a nicely precise definition. These investment banks make their profits from two principal sources: fees and investments.

Eye-watering fees are charged to corporations for various services, mainly capital-raising and merger and acquisition advice.

Although such fees add to the bottom line of banks and in theory generate tax (though these institutions are acknowledged experts in tax avoidance), they come off the bottom line of the corporations that have been advised, which will thereby pay less tax by a similar amount.

Whether the fees charged result in proportionate increased productivity is debatable. Certainly, mergers and acquisitions have a history of boosting pre-merger corporate egos rather than post-merger profits and synergies.

Changed businesses

The investment side of these banks’ businesses has changed dramatically in the past 25 years or so. The precursors of current investment banks were typically partnerships. The partners risked their own money and, not noted for their poverty, risks were carefully assessed before capital was ventured. There was much less activity than today and banks were smaller.

By the mid-1980s, ‘Reaganomics’ and deregulation had arrived and nearly all the old-style banks departed. They incorporated, pulling in large amounts of equity and debt capital.

Awash with other people’s money, and with their personal cash not at risk, bankers’ behaviour and activities changed. Financial engineering and innovation became the name of the game; in particular, the range of derivatives increased dramatically.

Derivative-driven calamities

The calamities that have befallen not just scores of banks, but also hedge funds and pension funds in the past quarter century have been inextricably bound up with two prime causes: derivatives, and an explosion of credit to fund trading them.

Derivatives, which have existed for centuries, are not assets. They are best thought of as being side bets about the way some metric, related to real assets, will behave at some time in the future.

The first were probably forward contracts for agricultural produce, which developed into standardised futures contracts. These were a brilliant invention for producers and end-users to hedge price risk. Traded through a clearing house, they became highly reliable instruments: they were enforceable, backed by a clearing house and therefore pretty much proof against default.

However, commodity futures go through periods of volatility, sometimes extreme. Futures contracts are also traded on margin, meaning only a small percentage of the face value need be paid initially. It is as easy to take a short position as the long side.

Wider range of markets

The range of markets and underlying instruments for futures contracts has expanded dramatically over the past 25 years, with the majority now financials. All these characteristics enable derivatives to be used not just for hedging risk positions, but as instruments of pure speculation.

This suits the largest players because, while there is finite availability of real assets like equities, bonds and property, the amount of derivatives that can be created is literally infinite. The number of possible deals is therefore constrained only by the amounts of liquidity available. The range of derivatives now includes swaps, collateralised debt obligations, etc, some undoubtedly made unnecessarily complex to confuse and catch unwary counterparties.

The trading partners in these deals are usually the big investment banks, sometimes trading with each other, but derivatives are often sold to pension funds, insurance companies, hedge funds and other institutions. Some even leak through into retail products.

Flawed assumptions

As in virtually all modern quantitative finance, the models used to create these instruments have relied on the deeply flawed assumption that the returns from financial markets are normally distributed, that is they form a genuine bell curve.

Most of the time (around 99%) markets behave in a way that fits a bell curve tolerably well. However, all the empirical evidence shows that extreme events occur scores or thousands of times more frequently than predicted in a true normal or Gaussian distribution.

The quants and rocket scientists know this. Whether senior risk managers do is a moot point, but the mathematics of more complex (but more realistic) probability distributions is simply too difficult, requiring too many subjective assumptions at the extreme, to make the effort worthwhile.

In aggregate, the industry is happy for the equations to work (and make money) nearly all of the time and hope that when a market crash occurs they will not be involved, will be on the right side of the bet or, most likely, will be in no worse position than the rest of the herd.

Zero-sum systems

From a risk perspective, the key point about derivatives, all derivatives, is that they are zero-sum systems: for every pound profit on one side of a derivatives contract, there is a pound loss on the other; and that is the best case scenario. With modern, highly complex derivatives, the fees charged for creating them and the commissions paid for selling them mean that trading them is, in aggregate, a negative sum system.

This element appears to have been ignored by the media in the analytical frenzy following the crunch and crash, but its importance cannot be exaggerated. It was never possible for all the derivatives players, in aggregate, to all make profits all of the time and it never will be. Derivatives are at best a zero-sum system.

This fundamental flaw is exacerbated by the ubiquitous use of credit to trade. Mostly, individual trades make tiny returns and can only be translated into high profits by high levels of gearing. US hedge fund management firm Long-Term Capital Management failed in the late 1990s with gearing of around 30:1; in the recent crash, levels were approaching 50:1.

As economist J. K. Galbraith noted, financial crashes are always associated with huge expansions of credit. Massively gearing zero-sum investments does not make bankers coruscatingly clever or worthy of Croesus-like bonuses and is likely, in aggregate, to end in tears.

Counterparty risk

Like all good bookies, the banks laid off their bets with each other and with anyone else willing to take the other side of the deal. This process looked like diversifying risk but in fact it added new risk to the system: counterparty risk.

The hugely complex network of myriad contracts criss-crossing the financial world becomes exceptionally brittle and weak. If a single fracture occurs or a single institution defaults, the domino effect may be cataclysmic, like the one that followed the collapse of Lehman Brothers.

Also, it is scarily easy to hide losing positions off-balance sheet. There are bound to be hideous losing positions that are still being endlessly rolled forward until (like Barings, SocGen and BCCI) one day these losses will come to light and have to be booked.

No economic value

Unless used for directly hedging risk positions, in aggregate all derivatives trading appears to be of zero net economic value; no new productive element emerges. The winners make profits and presumably pay taxes, but with balancing losses and no taxes for the losers. It is as if an entire economy were based on gambling, restricted to professional bookies who perpetually win and lose money from each other. Some may flourish and expand but at the expense of those who go bust and lose jobs. In aggregate there is no net economic value in people betting with each other.

Former UK prime minister Gordon Brown and US Federal Reserve chairman Ben Bernanke may have felt a testosterone rush at the virility and energy of their mega-investment banks. But why did they not realise those banks were taking on derivatives risks with no possibility, in aggregate, of net profits? Perhaps they confused success and some tax revenues with a repeatable risk-controlled process that would generate genuine economic value and, given their aggregate size and ability to bring down a modern economy, satisfied a public interest test.

Reform the banks

It would be hoped that bankers, being at the heart of capitalism, understood the need to generate true economic value and satisfy the public interest. The provision of loans and liquidity at retail and commercial levels can be embraced as necessary and useful functions, so let those elements of banking flourish in a sensible regulatory framework.

As for Cable’s ‘casino banks’: why should anyone respect bankers who do nothing more than gamble with other people’s money for zero net benefit? Let them become hedge funds. The best will do well and others will blow up, losing their investors’ money. That is modern capitalism.

However, those who play the game should understand the risks being taken with their pension funds’ money. Statistically, at least half of them can expect to lose.

Keith J Robertson is managing director of Armstrong Financial and Chartered Champion for London for the Personal Finance Society.

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