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Bankers: are they good or bad today?

This is the fifth in a six part series that looks at whether bankers are good or bad for society:

[If you just want to get the slides and download the
whole speech, click here
]

Today, we look at the nature of how bankers have been involved in creating, fuelling and contributing to the most recent financial crisis.

Bankers today

In the same way that previous crisis enabled expansionism, growth and progress, so it is with today’s crisis.

Today’s crisis allowed and was fuelled by globalisation and technology which, in fact, were two revolutions taking place in combination – the revolution of global trade and the revolution of the networked economy.

This makes today’s crisis different to the preceding ones.

In fact, you could say that the internet bust of 2001 was the stutter before the fall which, when it occurred, made us all realise how networked and inter-twined our economies are, not just the economies of Europe and America, but the global economies of all nations.

A second striking point of today’s crisis is that it demonstrated how much our financial instruments have become divorced from trade and commerce. This is due to the complexity of today’s trading technologies. These trading technologies allow ‘rocket scientists’ to create financial instruments that even the most intelligent MENSA graduate could not understand. Add on to such complexity the fact that these are globally mapping, wrapping and intertwining all economies and trade globally, and you can see how these markets became dangerous and potentially toxic.

The delinking of goods and services from trade and finance, through globalised financial markets networked through technology, is a root cause of this crisis and its loss of focus upon risk.

Equally, the moral compass moved.

Today, most of those working with finance have little fear of God or gods. Therefore, there needs to be some new form of fear: the fear of regulation.

But this industry was highly regulated … or was it?

Well, there’s a fascinating insight into this market from comments made years ago.

The year was 1987 and Wall Street the movie, with that immortal line Greed is Good, had been released based upon the exploits of investment bankers.

A book had also been written at that time called Liar’s Poker and, in the book, there is a direct quote from Donald Feuerstein, the head of legal counsel at Salomon Brothers where Michael Lewis worked, that goes like this:

My role is to “find the chinks in the regulators’ armour”.

It was obvious that the only way to make money was to buck the system and create risk. That is an investment bankers’ job.

This book leads me to another great book: “Infectious Greed” by Frank Partnoy, which reviews the history of arbitrage and derivatives.

In the book, Partnoy traces the history of these tools and each time demonstrates how the risk models behind derivatives were fatally flawed.

He begins with the invention of derivatives risk models by Fisher Black and Myron Scholes in the 1970s. Their model looked good, but proved to have fatal flaws which led to disastrous losses.

In particular one firm, Salomon Brothers as described in Liar’s Poker, used these tools to arbitrage leading to the ultimate destruction of the firm which has since been acquired by Smith Barney adn subsequently Citibank.

The man who many claim destroyed Salomon’s – John Meriwether – moved to his next big arbitrage adventure: Long Term Capital Management. This was another venture that failed massively when the firm collapsed in 1998 and almost destroyed the world’s financial markets with it.

Amazingly, Mr. Meriwether continues his trail of destruction to this day, setting up a new hedge fund only three months after closing his latest fund manager, JWM Partners, after clients saw the value of their investments fall by more than 44% during the course of the financial crisis .

Meanwhile, Partnoy’s book continually shows how derivatives create arbitrage, arbitrage creates risk, the more risk the more profit, the ultimate risk however creates the ultimate losses.

You therefore have this toxic mixture of technology creating ever more complex instruments based upon rocket science risk models that feed derivatives tools to generate arbitrage risk.

However, ultimately, it is all just speculative trading where someone wins and someone has to lose. This was demonstrated time and time again through the dotcom boom and bust; the way in which derivatives contributed and were largely responsible for the Enron disaster; and ultimately by the trillions of dollars of losses of the subprime and ensuring credit crisis.

Throughout the book, it is clear that these complex tools are being used, with technology, to create massive risk and yet, in every instance, the risk models they are based upon are fundamentally flawed.

This is why we end up making massive losses.

No wonder Warren Buffett referred to derivatives as “weapons of financial destruction” although he said that way back in 2002 when Enron collapsed.

Alan Greenspan, the head of the US Federal Reserve and Economist in Chief of the largest economy in the world, said: “It is not that humans have become any more greedy than in generations past. It is that the avenues to express greed have grown so enormously”, at that time. And yet it was distinctly Greenspan’s policies of free market economics that led to this crisis.

When the USA was faced with the dotcom bust and a potential systemic crash of the financial markets thanks to this and other factors, Alan Greenspan cut interest rates from 6.5% in 2000 to 1% in 2003. The apparent success of that strategy made Alan Greenspan a US hero but, just four years later, American markets imploded as the low interest rate environment had combined with a new kind of greed: mortgage market derivatives.

Again, a market based upon derivatives and again, a market based upon derivatives that had flaws in their risk models.

The risk model being used had been designed by a math wizard, David X. Li, who everyone thought, even in 2007, that he might someday receive a Nobel Prize.

Today, his name is mud as it was his formula that screwed the markets.

His formal, known as a Gaussian copula function, seemed to be a massive breakthrough when it was first released upon the world as it allowed hugely complex risks to be modelled with more ease and accuracy than ever before.

However, his risk models were based upon theories, not real world market movements; and the real world never moves the way theoretical models do.

For example, his theory used standard deviation points that would occur only once in a 100,000 years … and yet sometimes they occurred several times in a week.

The first sign of this was seen on August 14th 2007 when Goldman Sachs' systems lost 30% of their flagship global equity funds value in a week, because their systems made incorrect assumptions.

David Viniar, Goldman Sachs' CFO, said: "We are seeing things that were 25-standard deviation events, several days in a row. There have been some issues in some of the other quantitative spaces, but nothing like what we saw last week."

Apparently, a "25-standard deviation event" only happens once every 100,000 years or more according to the models built into the systems, but then they occurred last week and the fund lost around $1.5 billion.

Some would say that something that should take place every 100,000 years also seems to be starting to occur with more frequency. For example, Lehman Brothers made an announcement in the same week that: "models are behaving in the opposite way we would predict and have seen and tested for over very long time periods."

That is not good, as we now know.

And it is all
related to risk created by flawed models fuelled by complex technologies intertwined globally to allow greed to be expressed in new ways.

This is why these markets have been so hard to regulate – bearing in mind that the focus is to create risks by identifying the “chinks in the regulator’s armour”.

Added to which, the Greenspan and Anglo-Saxon approach to market regulation failed.

Free market economics and free market forces felt that the market would regulate its own dynamics. This is why the USA and UK took a light-touch approach to regulation.

How wrong could we be?

There was also a failure as, with no fear of regulation or other issues, the money managers were untethered from constraint and greed could run rife.

The result is that bankers were managing money without effective risk management.

If you are unsure of that one then let me illustrate with the comment that, just before the ABN AMRO merger, I presented to Royal Bank of Scotland’s internal Risk Management Conference. The Bank had risk managers for operational risk, market risk, credit risk, reputational risk, environmental risk, regulatory risk … you name it, they had a risk manager for it.

2,500 of them globally.

But there weren’t any managers for liquidity risk or to manage the complex global technology interlinkage between real world and virtual markets.

Finally, we have the role of technology.

Technology created a world where screen based traders working in high frequency trading rooms could make or lose billions in a microsecond.

The €7 billion losses that Jérôme Kerviel made at Société Générale were, some would say, down to the fact that he only saw spreadsheets, digits on a matrix, a screen full of pluses and minuses.

This testosterone fuelled world of trading machismo is, in fact, very akin to playing video games.

The emotions and brain activity is very similar for a trader as it is for a videogamer.

In fact, if you look at a video game convention, it could be a trading floor.

So there are several big differences between this crisis and previous ones: first, technology has divorced trading from reality; second, the crisis is a global one, not just related to a singular geography or nation, as all nations are tied through technology and trade this time around; third, that risk models and risk management were fatally flawed; and finally, “that the avenues to express greed have grown so enormously”.

The result was a form of casino capitalism, where bankers plied their trade using screens of numbers. In the real world, we can see the real value of our goods and services, investments and operations; in a pure play world of complex arbitrage using investment vehicles that are once, twice or three times removed from the real assets they link into, it is hard to see the risks involved or the realities.

For example, the failure of a dealer with $2 billion in Credit Default Swap contracts – a form of derivative that lies at the heart of htis crisis – outstanding could lead to losses of between $36 billion and $47 billion for counterparties in those trades, according to a report by Barclays Capital last year. There is the core of the issues we face today in the capital markets, as no-one knows their total exposure to losses and the losses made are magnified ten-fold.

Lehmans collapsed with $400 billion of losses on the balance sheet. Based upon the numbers above, this would equate to $7.2 trillion to $9.4 trillion of losses in the market.

Who had them? Where were they?

No-one knew and that is why the markets dried up.

And $10 trillion of losses could be the amount for just that one failure. What about the rest?

This is why governments have had to pump in almost $11 trillion to keep the lights on in the financial markets so far throughout this crisis, and why it is no wonder that banks have written off $1.6 trillion to date.

And now to the point about whether bankers are good or bad for society: they are only as good as their constraints.

Without constraint, bankers will lose their moral compass and indulge in the ultimate sin of greed.

The constraint used to be fear of God and is today the fear of the regulator.

And yet, the regulator’s cannot regulate a market that is so complex and divorced from reality.

When banks are run for the common good, they run in the rose-tinted manner as sung by Mr Banks in the film Mary Poppins:

“A British bank is run with precision
A British home requires nothing less!
Tradition, discipline, and rules must be the tools
Without them – disorder! Chaos!
Moral disintegration!
In short, we have a ghastly mess!”

When bankers are allowed to be bad, then we have a ghastly mess. And that is just what we have this time: a ghastly mess.

This ghastly mess is to blame on the bankers’ moral compass losing its direction and not having strong tethers to reign it back in.

However, bankers have still been good for society today. They have allowed the expansion of trade and commerce to move from regions to globalised industries; they have fuelled work and lifestyles for many to enjoy an unprecedented period of stability in the world’s economies with wealth and comfort for many; the financial system has allowed us to start talking about a billion new consumers in the BRIC economies who are becoming middle class, whilst also considering creating new ways of working entirely through the networked economy; and the combination of innovations in technology and financial markets has meant that we can see huge improvements in gaining access to capital and liquidity when required.

But banker’s today have also been bad for society. They have lost their moral compass and become greedy to the point of inciting civil unrest; they have behaved irrationally without any recognition of the risks they are taking; they have gambled on world markets with capital and assets that belong to others; and they have destroyed companies, lives and economies through reckless trading without control of risk.

In the final part of this series on Monday, we will propose some idea on the future of banking and how bankers can be a force for good.  Then, on Tuesday, the full script and slides will be available for download.

About Chris M Skinner

Chris M Skinner
Chris Skinner is best known as an independent commentator on the financial markets through his blog, the Finanser.com, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal’s Financial News. To learn more click here...

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