Proposed Restrictions on Proprietary Trading are a Joke

I was prompted (thanks to an article on Bob Diamond, which reminded me of him) to Google for Martin Taylor's contribution to the Banking Commission's enquiries. I found them here. And quite interesting they are too, especially for me. I met Taylor once, when he interviewed me for a job at Barclays back in the early 1990s. I found him to be extremely frank and open about the problems that Barclays had then recently been having, and I'd attach a lot of credibility to his comments on the banking system, not least because I've seen many aspects of his concerns first-hand.

Here are some extracts from his comments:

The second thing that I’ve been critical of is that when banks write derivative transactions for customers the fees which are paid, very small fees which are paid year by year over the life of the transaction are rolled up into a single net present value and charged a profit in the year in which the transaction is written rather than over the life of the transaction. Traders love this because half of the profit is usually paid out to them and so they would naturally like to write very long transactions and very many of them. And if anybody wants to know why we have such a large volume of outstanding derivatives, that’s why, the accounts with it.
There are other things where I’ve criticised not the accounting standards itself but the understanding of them by the boards of directors of banks. In particular the habit that banks have got into before the crash of paying out large bonuses when the profits were purely notional, they didn’t have a cash component. This is obviously a dangerous thing to do.......

I think there are serious dangers and if you are going to have universal banks you’d better be sure you regulate them very carefully and very hard. Our investment banking activities, valuable though some of them are, very valuable, some of them are not. And the trouble we’ve got into is when the non valuable activities have been combined with an excess of leverage which has put the whole organisation at risk......

Boards have clearly had a terrible crisis. The, I think the boards in the financial sector across the world, this isn’t a British phenomenon, one can say have just not performed the task they were there for, and you can ask why. One of the reasons is the complexity, and increasing complexity of the financial industry. Most non executive directors of banks do not understand the industry they are supposed to be looking after. It’s very difficult for
them to say, I’ve been on this board for four years and I haven’t understood a word, because
they’re all important men and women. But I think that they’re very easily fooled by it and the
shareholders of course were enjoying the ride too. But certainly both those groups have to ask themselves some questions.......

the institutional shareholders of course are beneficiaries of the financial industry bonus culture themselves so they tend not to ask very fundamental questions about it because they’re part of it.
PHILIP AUGAR Do you think Walker will fix this?
SIR MARTIN TAYLOR No. No.
DAVID DAVIS Why not?
SIR MARTIN TAYLOR I just think that fundamental reform of, fundamental reform of a
system from which so many people make so much money so much of the time, so many influential people, is very difficult. I found this at Barclays when I challenged the investment bank. The investment bankers don’t like it David.....

the fathers of Basle, including Peter Cook at the Bank of England here, never believed I think that Basle was supposed to replace the judgement of bank boards as to how much capital they ought to have. Unfortunately the model became have as big a book, ie as little
capital as Basle allows you to have. Gear up within that capital as much as you can and chase the marginal asset, ie it was a leverage model based on something that was supposed to go a different way. And I think there does have to be structural reform of a system that’s been so abused.....

I do think we have to think very hard about people’s ability to buy credit insurance on credits they’re not exposed to. George Soros has written very brilliantly about that, because it’s effectively a way of taking a short position with a long instrument. So it’s not a particularly risky, it isn’t a particularly risky way of betting on someone’s collapse and we don’t want to give people low risk ways of betting on people’s collapse....

...and he went on to make other interesting comments on the subject of corporate governance, accounting and audit for large banks.

One might have some hope that some of the actions that follow the conclusions of the Commission will turn out to be reasonably sensible .

ee

ps...the Commission's report is here, I now note:

http://commission.bnbb.org/banking/sites/all/themes/whichfobtheme/pdf/commission_report.pdf

.....its a bit of a shame that they didn't seem to take evidence from any/many people with sharp-end experience of the derivatives market. Certainly none of the 6 people who I know personally and who gave evidence has any sharp-end experience.

I notice that there is a good piece in the FT on this topic:

http://www.ft.com/cms/s/0/1705ff00-0774-11df-915f-00144feabdc0.html

On balance, however, the proposal to restrict the scope of large financial institutions deserves serious consideration, even if proposed by an embattled administration as a response to political pressure. Put simply, the economic gains from combining commercial banking with proprietary trading appear non-existent, while the costs of allowing such combinations seem enormous. But such a separation is just the beginning of what is needed to manage the risk presented by too-big-to-fail institutions.

The writers are professors of finance at the NYU Stern School of Business

It is interesting to consider the fact that prop trading by commerical banks is a pretty recent activity. It was certainly a real novelty 20 years ago (when I was working in capital markets for some major global banks) and was very much "the new thing" at that time - along with the idea that commercial bank treasuries should extend credit lines to hedge funds so that they could profit from the information value offered by their chunky positioning (by adjusting their spreads to customers based on this "inside information")......

....it took less than a decade for "everyone" to be doing it!

ee

Credit is critical to the functioning of any economy beyond the barter stage. As economic activity became larger in scope and scale, and banks increasingly became the dominant credit providers, bank panics became a serious threat, and so various safety nets have been deployed under traditional banks, the biggest being deposit insurance and access to the central bank discount window. The quid pro quo was that banks were subject to strict limits on their activities and intrusive supervision. But those were eroded over time while the safety nets, if anything, became more extensive (consider unofficial support activities, such as Greenspan engineering a steep yield curve after the savings and loan crisis).......

I would see the mechanism (by which mission-creep in bailouts actually came about ) as being a lack of political will to let institutions fail. Accordingly, safety nets have always tended to grow in extent and scope - and only the taking of some really tough decisions could stop this! Going back 12 years it seems pretty clear in retrospect that letting LTCM go under would have been a salutory lesson for Wall Street.....not doing so at the time has probably contributed to circumstances that led to the letting-go of Bear Stearns and Lehman actually proving to be insufficient to prompt observably-greater caution without further regulation - which is pretty astonishing when one thinks about it.

But now we have a world in which the credit markets are crucial to modern commerce, more so than banks. It would not be all that hard to break up the traditional commercial banking operations of Bank of America up. By contrast, once you get past hiving off non-capital-markets operations like asset management and commodities trading, it would be much more difficult to break up Goldman Sachs. And perhaps more important, absent regulation, it would tend to re-evolve back into its old format. A set of oligopolies, with information synergies among them to boot, is an extremely attractive business proposition.

So any capital markets player of reasonable heft WILL be backstopped. That was the big lesson of the crisis just past and is not lost on the industry incumbents.

I have highlighted a good point - and this is perhaps where the focus of regulation should fall. It isn't the deposit-taking side of institutions that has, in most cases, been much of a problem - it is their capital market activities. Surely the answer is to restrict the absolute size of capital market businesses (which would mean that the likes of Goldman should be split up, IMO)?  And, when it comes to prop trading, surely the answer is to place absolute limits on the amount of capital that can be used to support trading positions........

.......because if banks/IBs are prevented from taking substantial positions without laying them off, then they won't be able to store up systemic risk in the way that they have over the last decade.

I would find it astonishing if Governments fail to bring in effective legislation to limit the size of capital markets activities at individual firms - there are plenty of people out there who understand the capital markets well enough to frame some proper regulations! And, when it comes to hedge funds, again absolute limits on size should apply.....say $1bn of capital. Managements then need to be kept completely separate from each other - so, if the end result is a large number of institutions, each of modest size and incentivised to act wholly independent of each other, then systemic risks should be lower and ignorant groupthink in the institutions' boardrooms should be far less damaging when it occurs!!

ee