01.27.10
Posted in Blog at 2:36 pm by Andrew Clearfield
The following was written in response to an article by Martin Wolf in the Financial Times, “Volcker’s axe is not enough to cut banks to size,” on January 26th, 2010, questioning the viability of the Volcker proposals to prohibit commercial banks from engaging in proprietary trading. In particular, Mr Wolf wondered whether it would be possible to distinguish between transactions carried out on behalf of clients, and those done with the bank as principal, for its own profit.
Is it really necessary for banks to assume so much risk on behalf of their clients that the hedging of said risk would constitute such a large portion of their activity as to permit them to hide proprietary trading within it? In my experience, a great deal of what banks do for clients is (a) immediately sterilized, or (b) laid off upon other clients, or (c) grossly exaggerated. Banks don’t “risk” much on behalf of clients, although they may speculate in parallel with them, or even against them.
One also must question the wisdom of a financial system in which a financial intermediary is called upon to assume on its own risks better borne by a corporate issuer or bidder, or by natural investors in the market, such as pension funds, mutual funds, hedge funds, and insurance companies. If buying a deal was necessary in order to land the business, perhaps that indicated that there was too much investment banking capacity chasing too few corporate deals; more likely, it was because the banks had figured out how to make larger profits by acting as principals, i.e. engaging in proprietary dealings of one sort or another.
Now that we have figured out that such proprietary activity is dangerous to the stability of the whole financial system, we ought to be able to go back to syndicating much of the risk through the marketplace, using properly registered standardized instruments, cleared through an organized market, rather than relying upon impromptu over-the-counter creations and ad hoc agreements which can create enormous hidden risks in an invisible marketplace. Similarly, it seems to me that much of the shadow banking sector is composed of organizations having their own specialized mandates that should mitigate against their being abused by serving as tools for some unrelated dealing for their own account—at least if they were being properly regulated. Of course, this would mean that such organizations could also not be controlled by deposit-taking banks. But why would that be a problem, except to empire-builders within the banking sector?
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01.23.10
Posted in Blog at 2:43 pm by Andrew Clearfield
An article contributed by Mike Konczal to the National Review Online, discussed the proposed reform of the banking sector to prohibit commercial banks from engaging in proprietary trading. The author was generally in favor of such a ban, but quoted the Congressional testimony of Lloyd Blankfein of Goldman Sachs, Jamie Dimon of JPMorganChase, and others, that proprietary trading was a small part of their activities, was a necessary part of their service to clients, and did not create any conflicts of interest. Such mendacity roused me to submit the following piece to the NRO.
I hate to publicly declare that a major public figure is lying, but as a long-time institutional investor, I must say that Mr. Blankfein and other leaders of the banking industry are at the very least being economical with the truth. Everyone knows that bankers’ trading desks position themselves against clients, especially when they are sponsoring a major underwriting. Everyone knows that they cannot trust their stockbrokers and their analysts any more; this is why institutional investors have spent hundreds of millions increasing the size of their in-house analytical staff.
Unfortunately, not only does the creation of such a huge staff dilute the pool of available talent, it also does not ameliorate the problem that such analysts do not have direct access to the marketplace and therefore can only judge the fundamentals of an investment opportunity according to an abstract standard. In short, Wall Street analysts used to perform an invaluable and irreplaceable function that is no longer being performed because all of the major stockbrokers are now components of integrated investment banks, which earn far more from underwriting new issues than they do from agency broking (which has become a loss-leader).
Then there are the banks’ in-house fund management operations, which have also been known to stuff their clients with securities they would not otherwise have bought, in order to cement a relationship with a corporate client, woo a prospective corporate client, or help out an underwriting that is in trouble. These are fundamental conflicts of interest, which would inevitably occur even if the organization were somehow able to keep its traders from front-running a major order, or ‘conditioning’ the market in behalf of an especially good broking client (usually a hedge fund nowadays, as these are such a huge source of commissions.)
Next, let’s talk about conflicts that arise from the universal banks’ situation as transfer agents and custodians of securities who often provide stock loans (of clients’ shares, not just their own) to their trading desks both to support their own proprietary trading activities and to facilitate the construction of derivative positions for their hedge fund clients. They determine the rates paid on securities loans and implicitly, the difficulty any traditionally long customer will experience upon attempting to ‘recall’ the loan (i.e., be bought back in.)
This is before one examines the economic logic of having government-backed entities, using insured deposits, to speculate upon markets, entirely for the benefit of the desk doing the speculating. Sure, they claim to have ‘Chinese Walls,’ and they even have a few compliance people to try to enforce them. Any desert nomad who couldn’t figure out how to get through these Chinese Walls doesn’t have the IQ necessary to get a job on the janitorial staff, let alone a responsible position in an investment bank.
When the big Wall Street firms, already riven with conflicts, began to merge with other financial organizations, and later with commercial banks, they always made sales pitches to us as investing institutions, telling us how their increased capital base could be put to work in our behalf as brokerage clients. They made the same pitch to their corporate clients. Twenty-five years on, clients are still waiting to find out how this increased capital will help them. What it has done is to put what used to be a hundred-odd competing organizations in the U.S., and perhaps a thousand world-wide, into an oligopoly of one or two dozen conflict-ridden universal banks so entangled with the ordinary flow of capital around the world that governments must prop up each and every one of them to prevent a melt-down of the entire system.
Risk-taking is a necessary part of any business, and the financial system is no different. But to claim that those who run the greatest risks must be protected from the consequences of their mistakes by taxpayers the same way that most ordinary, low-risk financial transactions need to be protected flies in the face of every form of logic, as well as three-hundred-odd years of financial experience.
Major risk-takers should be isolated in specialist partnerships, where they gamble only with their own money. More typical and socially-useful risk-takers (underwriters, insurers—including creators of derivative positions to hedge against risk, fund managers) should probably be herded into distinct organizations where conflicts of interest are less likely, and where the shareholders of the organization alone bear the risk of failure. Commercial banking, the guardianship of the vast amounts of capital necessary for the ordinary transactions, demand deposits, term loans, and financing of asset-backed transactions, should go back to being the risk-averse activity it traditionally has been.
The providing of electricity, gas, and water to businesses and households long ago ceased to be an exciting activity because it became too essential to our continued survival as a society to allow anyone to have fun manipulating the companies performing these services. The flow of basic money is no less essential to our continued functioning as a developed society, and should be subject to the same restrictions.
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01.22.10
Posted in Blog at 2:52 pm by Andrew Clearfield
(In the Wall Street Journal’s Law Blog on Friday, 22 January 2010, there was this item, regarding the White House’s call for proprietary trading to be severed from commercial banking):
Are Obama’s Bank Reform Proposals Good News for Lawyers?
By Ashby Jones
The stock market sure didn’t respond well to President Obama’s calls on Thursday to regulate the size and activities of the nation’s largest banks. (The Dow Jones was down over 213 points).
But how did lawyers respond? From what we’ve seen so far, it was a mixed bag. Allen & Overy’s Doug Landy, the head of the firms’ U.S. bank regulatory practice, isn’t a fan.
In an email to the Law Blog, Landy wrote:
The Obama proposal on limiting bank size and principal activities is a troubling concept that is neither supported by the evidence of the causes of the credit crisis nor well designed to prevent future systemic risk issues. If either being a large bank, or engaging in agency and principal activities in the same entity, were so inherently risky as to require banishment, every European bank would be collapsing as we speak.
As European banking is something I know a little about, I could not resist responding to this argument, rooted as it is in most Americans’ relative ignorance of financial markets other than their own:
Good try on behalf of your clients, Mr. Landy, but the argument doesn’t hold up. The European universal banks are regulated and protected by their national treasuries to a degree that all Americans—both bankers and taxpayers—would find intolerable. The culture is different, and most traders and other capital markets types in these banks work (under conditions of much greater job security) to gain promotion, not to become instantly wealthy and contract themselves out to the highest bidder each season. The senior executives are often ex-civil servants themselves, and in any case, are far more responsive to a telephone call from their country’s finance ministries than are their American or British counterparts.
The Continental banks were traditionally stodgy, and much less prone to finance risky enterprises, which has helped make their economies less dynamic than our own. After two decades of expanding into riskier activities, most are still far more risk-averse and top-down managed than our hybrid investment/commercial banks. Even so, little Jérôme Kerviel was able to start a run on the Société Générale just by engaging in a little unauthorized trading in order to impress his boss and earn a slightly bigger bonus (laughable by New York or London standards). The Trésor had to come to SG’s rescue.
Then there is the wonderful example of UBS, which tried to follow the American model and managed to lose more money faster than any bank in history. It is now a ward of the Swiss state. The trading mentality is inimical to the prudence necessary to run a commercial bank, and the very necessary function of significant risk-taking should be taken on by separate organizations that are not also insured and protected by governments because they accept demand deposits, clear everyday financial transactions, and serve as the gatekeepers to most everyday economic activity. The marriage of risky investment banks with risk-averse commercial ones was made in Hell, and deserves to be undone at the first opportunity.
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01.18.10
Posted in Blog at 2:56 pm by Andrew Clearfield
In response to an article in the WSJ by John Bogle, entitled “Restoring Faith in Financial Markets,” on January 17th 2010, I wrote:
Spelling out the duties of fiduciary investors is a good idea—so long as those duties are properly defined. Nebulous language wouldn’t be any improvement over the nebulous term ‘fiduciary’ we now have. One important aspect that Mr. Bogle has missed would, I believe, be key to changing the way institutional investors deal with the managements of companies they own: a legally enforceable duty of responsible stewardship on the part of major shareowners toward the companies they have invested in.
If an institution has a large position in a company—say, more than 5% of a small company or 1% of a large one—and it fails to have documented involvement (as measured by meetings with directors and responsible shareholder votes) in a company which then gets into serious trouble, the beneficiaries would have a cause of action against the directors of the institutional investor. Yes, this would lead to more litigation, which seems like a horrible idea. (Perhaps, in compensation, the right to derivative shareholder actions could be reduced.) But can anyone come up with another solution which will finally make institutions take their role as shareowners seriously? After thirty years in the field, I cannot.
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01.16.10
Posted in Blog at 11:27 pm by Andrew Clearfield
(The following was written in response to an opinion piece in the Financial Times on January 12th 2010, attacking the notion that a restoration of Glass-Steagall would improve the financial system. Mr. Pozen’s remarks were also supported in a reader-submitted comment by Bevis Longstreth, who argued as well that the original Glass-Steagall Act was a mistake, because it did not address the causes of the many bank failures of the Great Depression. I did not deal with this directly, although I think he was mistaken in assuming that Glass-Steagall was aimed primarily at the bank failures; rather it was in response to the Great Crash of 1929, which was then believed to have been the primary impetus for the Depression.)
I believe Mr. Pozen’s emphasis is mistaken. The point is not to re-impose a Glass-Steagall type of separation in order to make all banks bullet-proof, but in order to make the financial system more bullet-proof. That the smaller, weaker components of the system are more likely to fail in time of extreme stress is hardly surprising; the problem is what the strongest, best-connected components did to make the whole system so vulnerable. A system which enables massive speculation by giving proprietary trading operations access to depositors’ funds and inter-bank capital infusions is inherently riskier, especially since the lower cost of capital enjoyed by such operations in turn encourages their competitors to take more risks merely to keep up. The availability of such capital progressively corrupted the whole system.
While it is true that those banks that actually collapsed became insolvent primarily due to over-involvement in subprime real-estate lending, rather than in capital markets activities, Citigroup and Bank of America, the two largest commercial banking entities in the United States, were in danger of folding precisely because of their investment-banking activities. There was never any doubt that the U.S. government would move heaven and earth to try to keep them from going under; that was exactly the problem. Their risk-taking enterprises were effectively protected by being under the same umbrella as the giant commercial banks. Do Mr. Pozen and Mr. Longstreth honestly believe this did not affect their trading and underwriting operations’ attitudes toward risk?
Admittedly, the exact split in activities that Congress imposed in 1933 may not be the ideal solution for the industry as it has evolved since then. But the basic concept, that those involved in the higher risk activities in the marketplace should have to submit to the discipline of the possibility of failure, was and remains a good one. I would argue further, that inherently risky activities, such as proprietary trading, should be banned not only from commercial banking entities, but from stockbrokers as well. The ordinary flow of securities around the marketplace, from one retail customer to another, and from one institution to another, should not be jeopardized by the speculative activity of a small desk of specialists, with what they think is an unbeatable algorithm, in quest of eight-figure bonuses for themselves with no concern for the risks they are imposing upon other clients of the business. Moreover, the inherent conflicts of interest this introduces, with trading desks frequently betting against the advice they are giving their own customers, is of unspeakable proportions.
As older readers of the FT are aware, prior to 1986, such conflicts were impossible in the U.K., absent fraud. Those who advised and dealt with outside clients were not allowed to take positions for their own account, and those who took positions for their own account were not allowed to deal with the general public. Fund management was kept separate from market operations, and underwriters were not allowed to sell securities directly to the public. It was under the pressure of American investment banks, eager to break into the London market, and waving fistfuls of (shareholders’, not their own) money in the faces of partners whose capital was tied up in their own firms, that U.K. authorities decided to change the rules. The consequences were that many City types became rich through huge payouts, but no one has yet proven that the users of the financial system, whether issuers or investors, have done any better as a result. However, the integrity and safety of the British financial system have been hugely compromised.
The fact is that the only common factor running through most of the financial businesses today grouped into entities called banks is that they are all concerned primarily with money. Corporate finance advisors have nothing in common with traders, stockbrokers have nothing in common with either, and the business activities of all three are often inherently in conflict with one another. Fiduciary financial advisors should have nothing to do with any of the others. Putting them all under one roof and creating “Chinese walls” that any desert nomad with half a brain could ride right through is no answer. If all the financial cross-fertilization is truly necessary, then some of these activities aren’t earning their cost of capital, and should be eliminated, or some others are consistently too profitable, which almost certainly means that too many risks are being run.
Universal banks are only safe when, as in Germany until the 1990s, and in other highly bureaucratized financial systems with very strong state control, they are run with extreme conservatism, under the very heavy hand of otherwise excessive governmental regulation. Such conservatism has historically put severe limits upon entrepreneurial activity and economic growth. I think this would be too high a price to put upon the whole economic system, just so that a few deal makers at the apex of the banking system can continue to have a good time, building empires and trading financial companies ad libitum. The whole financial supermarket model is profoundly flawed, and has got to go.
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01.12.10
Posted in Blog at 3:27 pm by Andrew Clearfield
Response to an article by Alan Blinder in the Wall Street Journal, “When Greed is not Good,” January 11, 2010:
Mr. Blinder’s well-considered analysis of the obstacles to financial reform is essentially a re-statement of why Congress needs leadership from the White House in order to accomplish anything worthwhile. Instead of trying to extend the Welfare State in the U.S., President Obama should be doing everything he can to fix an actual problem currently facing the country. No such luck: part of the heritage of the Left’s myopic obsession with the failures of capitalism as a system is an inability to deal with a structural problem within capitalism. They have been and remain too focused upon attacking our system in toto, and bringing the supposed benefits of social democracy to those relatively few currently outside the system, to even try to repair a malfunction that affects almost everyone.
Worse, a statist frame of mind makes them actually prefer to deal with a few CEOs of giant financial entities, rather than a broad assembly of participants in what the financial system should return to being: a free market. To this mindset, a centralized financial system they think they can command from Washington is actually better than a more decentralized system that responds to new information as a market should, by repricing risk. Thus they probably prefer one of the chief current flaws to any solution that might fix those flaws.
As long as the American Left—or “liberalism” as we prefer to mis-name it here—remains mired in this essentially Marxist world-view, they will have no useful contribution to make to running the country. The “Us versus Them” thinking that characterizes the current Democratic Party keeps attempting to divide the country into two polities that bear little or no resemblance to any meaningful picture of our society. It is probably a waste of time to expect any worthwhile reform to come from the current crop of Democrats; the question is whether one can expect any better from the Republicans, when and if they return to power.
Conservatives currently reject any attempt at government intervention, even if that intervention has the object of restoring a free-market system that should ultimately function with less government intervention. Winning conservatives over to the cause of reform is where would-be reformers should concentrate their efforts.
I received this rather tart note in response from one reader:
“even if that intervention has the object of restoring a free-market system that should ultimately function with less government intervention”
1. The government has proven itself to be absolutely unable to solve real problems.
2. Once the government gets its claws into something they can regulate and tax, they never let go.
To which I replied in turn:
Unfortunately, I don’t think we can abolish government. That leaves us only with the options of:
(a) trusting the financial system as it is now constituted to run itself without any supervision whatsoever, or
(b) trying to reform it, so that it can operate as a more-or-less free market, with a minimum of continuing supervision.
Having worked on Wall Street for thirty years, I would prefer the latter to the former. Empire builders make lousy investors, lousy traders, and lousy corporate advisors. About the only thing they do well is to negotiate special deals with governments. That’s the last thing we should want.
The same respondent came back with:
Had TARP not happened, what would have happened to the financial system? I’ll qualify my question by adding that I just pulled 100% of my cash out of the market because I just don’t understand what its doing.
My understanding is that the banks were fundamentally sound, it was their derivative positions that went south. I also understand that AIG took the double whammy of the 5 big banks plus the Fannie and Freddie portfolio.
So what would have happened if the big 5 filed for reorganization, AIG, Fannie, and Freddie filed for chapter 7, and the government stayed out of it?
I answered:
It’s impossible to know now, of course, but the most likely outcome is that the funding crisis would have continued to spiral out of control, as no bank was willing to lend any other the short-term funds necessary to continue operations. Investors would have sold everything in a desperate rush to get something out of the chain of bankruptcies, and share prices would have collapsed to almost zero. Without equity, every bank and almost every other corporation would have been worthless. The world would have stopped functioning for lack of cash: no one could even meet a payroll.
The banks weren’t so sound, either: many of them were levered to ten, twenty and even thirty times own capital, but that wasn’t the main problem: it was that cash must continue to circulate in the system or it dies rapidly. And no one will lend money to a bankrupt without holding collateral worth the full value of the loan. That collateral can’t be worthless equity or bonds that are likely to go into default. No bank can be truly solvent in the face of sudden massive demands to return capital, which is why one always needs a lender of last resort, and the power to shout, “Time, gentlemen,” when a run on one bank escalates to others. A totally unregulated capital market is almost a misnomer: it would be a black hole waiting to devour all its participants as soon as prices began to fall.
TARP was badly screwed up, of course, and kept changing its objective because events got out of control after Lehman was allowed to go bust. But something had to be done or the chain reaction would have continued to accelerate. This was what killed AIG: the CDS contracts they had written were suddenly all deep in the red (think of an insurance company that suddenly has claims against all of its policies.) Fannie and Freddie were the largest cause of the underlying bubble in real estate prices, and should never be allowed to loan money out like that again, but once the crisis got going they were almost irrelevant.
The question we face now is to decide whether to regulate banks to death so that they can never be in a position to take even unrecognized risks again, or whether to restructure the system so that no component of the system is so important and so interconnected with the rest that its failure would start the cascade of further failures. Or, we could wait until the next unpredicted event caused the chain reaction to begin again. I believe that a change in structure would be better than trying to regulate every single possible risk a market participant might ever take, and then discovering that there were new ones you hadn’t known about.
There should also be limits to how cautious you want to make the whole financial system, or perpetual stagnation will result. The Germans, who had the largest universal banks in the 1970s and ’80s, almost killed off their otherwise strong economy because these banks were required to be so conservative; industrial financing was largely done through the Euromarkets in London and elsewhere. If this is the price one has to pay for allowing enormous one-stop financial supermarkets, maybe we are better off without them.
(An hour later, having received a positive reply, I added:)
More and more support seems to be growing for some version of Glass-Steagall to be enacted. Paul Volcker, for instance, has recently been in favor. It wasn’t so long ago that everyone I knew was saying it was too late, that markets had evolved, that global corporations needed the outreach of global, universal banks, etc. Now, more and more observers of the markets are asking, ‘What, exactly, have all these innovations done for the corporate sector or for other users of capital markets?’ And so far, no one has come up with very much in support of them. Issuers love to have their underwriter buy the whole offering, of course: then, it isn’t the issuer’s risk any more. But they are beginning to realize they have to pay a lot in fees for the privilege of avoiding a day or two of worry. Derivatives are useful tools to manage risk, but only if they aren’t allowed to accelerate the destruction of a market. Institutional investors certainly haven’t benefited if, in exchange for lower transaction fees, they have to pay for more analysts, because they can’t trust the analysts on the Street any more.
I’d like to see a serious, independent study or studies of what it would cost to separate commercial banks from capital markets, and corporate finance from trading, and all three from money management. This is what we had before about 1985, and it seemed to be working just fine. What it bothered was the ‘vision’ of certain CEOs, who wanted their trading partnership to have unlimited capital to gamble—er, trade with, or their brokerage firm to be able to accept demand deposits like commercial banks could. The banks wanted to get into the sexier parts of corporate finance. But I never saw anybody actually ask their bankers for these services. And most commercial bankers learned to hate the variability of returns from capital markets activities, although they loved the much higher return on assets these sometimes gave them. But net net, I’d love to know who—other than the former partners or shareholders of smaller organizations who sold them for fancy prices—if anyone, came out ahead.
Of course, a re-division of the sector might happen de facto if salary caps and effective risk-taking limits are imposed on traders, deal-makers, and other risk-takers. They could gravitate to new and smaller organizations, and history could repeat itself. But there would still be the risk that a rising market in a few years could provide the capital for a new wave of consolidation led by new empire-builders who manage to find a way around commercial banking regulation. And there would still be the problem that even the riskiest activities were being funded by Someone Else’s Money. Re-thinking the architecture of the whole sector would seem to make more sense now, while there is still an opportunity and a need to do so.
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