This came via e-mail from a savvy past client with the sign off, “Frustrated on a plane.” I like all his suggestions, and I particularly call readers’ attention to his recommendation regarding compensation reform. One thing that is striking is that the media (and pretty much everyone in DC) has fallen in with the industry-flattering party line that pay is a third rail issue, that touching it is socialist, when our current taxpayer-subsidization of capital markets firms is tantamount to Mussolini-style corpocracy. By contrast, most people I know in financial services who are over the age of 45 believe that the only hope for a return to a financial services sector that has a healthy respect for risk is to return to something that approximates the old general partnership, where liability was unlimited, or greatly defers payouts, since many trades and activities involve long-tailed risks.
From a recovering derivatives trader:
I have to confess that I have officially crossed over to curmudgeon status. I long for the days when bankers actually cared about relationships, when transactions were used to service customers, and when the word fiduciary meant something. It seems that granularity of a relationship is now defined as a single transaction and the time horizon of both buyers and sellers is limited by the conclusion of the deal.
Aside from whining about being old, I am deeply saddened by the debate or more precisely the lack of intelligent debate about how to properly reform the financial sector. The wise old men of Wall Street (Volker et al) have more or less all said that we need some significant reform to create a value added financial service segment, and that we must return to an environment that is less about risk taking and more about service.
While I agree with their sentiments, I don’t actually agree with the prescription that the answer (or even part of the answer) lies in separating proprietary trading from “customer servicing”. The days when pure brokerage can be separated from proprietary financial intermediation and risk transformation are LONG gone. Further the issue is not really with taking excess risk in the banks’ prop trading desk. Instead I would suggest the fundamental causes of the crisis and the current state of the financial segment are fairly simple namely too much leverage, too much credit exposure, not enough transparency, and of course pay practices that encourage speculation on the firms, and worse, the taxpayers, balance sheets.
Of course these three things are interconnected as well, but let me do my best to put forward a segmented argument
Too much leverage – We all know that the prop trading books are not the proximate cause of the meltdown. Rather is is the loan book and the inventory left on the shelf from a clogged securitization pipeline. We have all seen the numbers of the dramatic increase in leverage of all banks – whether Investment or Commercial – so the issue is not a return to Glass Steagall separation. Rather is is about charging properly for capital use, mandating that off balance sheet item be put back on the balance sheet (as in the final analysis these off balance sheet items are not off balance sheet) and encouraging the use of exchange and other standardized mechanisms to reduce net exposure, and increase transparency. While we all understand leverage caused the crisis we seem not to be able to agree on a solution.
Further what I find lacking in the debate is recognition that even the management of these financial institutions did not understand their real exposure (go ask Marcel Ospel of UBS, if you doubt the truth of this statement) It seems absurd to me that if the management of the financial institutions didn’t understand the real risks that any regulator has a snowball’s chance in hell of understanding (and regulating) our way out of this mess. Too little of the debate has focused on the fact that financial instrument complexity coupled with the federally mandated power of certain rating agencies masked the real financial risk form both the internal mgmt team and to investors. So we need to attack the root causes of this excess leverage and lack of mgmt understanding of the real risks, i.e too much complexity.
Too much credit exposure – There was a reason the industry created mutually owned clearing firms and why the government exempted them from the cherry picking. We need to use these institutions to eliminate excess credit exposure that makes it impossible for mgmt, investors and regulators to actually understand the net exposure of one institution to another, let alone understand systemic linkages. We need to make more use of these institutions and penalize transactions that bootleg around these institutions.
Not enough transparency – This is a complex subject, but by transparency I don’t just mean the old notion of reporting prices of each transaction. I also mean enough transparency around contract specification and the modeling that justifies such complex transactions that everyone involved as a real understanding of what they are buying, selling, rating, intermediating or have somehow touched. The chief issue is balancing innovation with the real charge to the system of superfluous complexity. Off exchange contracts are less standardized than on exchange contracts. hence they are harder to understand (less transparent). So we need to charge for this complexity in a manner that still allows for financial innovation but insures the system against excess complexity increasing the systemic risk. Similarly OTC transactions that are significant deviations from ISDA or other recognized industry consortiums are more complex than standardized contracts, so charge for this complexity. Think of this as a complexity tax designed to encourage transparency and understanding for all
Asymmetric pay practices – Enough has been written on this topic, but a heads I win and tails you lose (whether it is the firm or the taxpayer, doesn’t really matter) should be corrected. I would simply note that none of these practices existed when firms were general partnerships with all of the personal liability that business form entails.
So what should we do?? I propose a FEW simple changes.
1. Variable capital and insurance charges – Part of the problem is that as a society we need to balance the role of legitimate financial innovation with need for a robust system. Most binary solutions, such as Glass Stegall prohibitions do not adequately balance these important objectives. Rather than general prohibitions, excepting my number 2 below, I would suggest variable capital charges. Capital charges should be designed to incentivize people to trade on exchange (where transparency, standardization and clearing firms eliminate or reduce much of the risk of complex instruments – after all in economic jargon the very complex instruments have a negative externality of confusing mgmt, the buyers and the investors who back such institutions, so we merely need a tax to incorporate that externality back into the market). Perhaps something like four times charges for any OTC transaction not executed through and exchange and double charges for anything executed OTC but cleared through a central clearing house. While we are a it the moral hazard issue of too big to fail could also be addressed through variable insurance charges – perhaps something like a stepped INCREASING charge for complex instruments. The rate could be set by an FDIC type insurance program for too big to fail banks – that funded an actual bailout fund. All of the clever details like have an organized liquidation plan etc now discussed could simply be the mechanism to help determine the actual insurance charge to the specific institution. Consider it the way to charge in advance for the bail out insurance the taxpayers have implicitly given every large financial firm
2. Make it illegal for financial institutions to transact off balance sheet. These transactions all seem to find their way back to the parent institution in a crises so we should just recognize that fact upfront and make prohibit this upfront (yes I know this violates my rule above, so maybe I haven’t thought this through enough) Yves here. I think the disconnect here is in 1. he meant more narrowly OTC trading of various sorts, while this prohibition fits if you think of it as applying to off balance sheet vehicles. The FDIC’s proposed restrictions on “true sale” (what you have to do to have a securitization be treated as a true sale, and hence moved off balance sheet) actually solves many of the problems of securitization, which is why the industry is trying to kill it. Back to the e-mail message:
3. Get rid of “mandated” rating agencies. Instead encourage the use of more open source type rating agencies that actually published and allowed others to comment on the models and model assumptions that underly their ratings
4. Change the incentive system so that “excess pay” is subject to clawback upon a firm meltdown. The issue is not just bonus and it is not just executive. So how do we define excess? I propose something simple like anything above 2 times the average income of a family in the US be escrowed and only available after some period of years (think of it as a rolling bonus escrow in which you slowly vest). To those that would comment this is impossible or unfair, then fine. Force all financial firms to become general partnerships and remove the limited liability shield for all individuals that make more than XXX. given this choice, I expect most managers, trader, employees of these firm would opt for an escrowed comp plan that rolled off through time
OK . So the above wouldn’t fix everything. But it would go a long way to correcting the system and the incentives to go in the wrong direction. Most importantly, it is simple, it is understandable and it attempts to reincorporate the proven mechanisms of past era into a more modern financial landscape
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I could be categorised as another in recovery from the industry, but I am rather too jaundiced to think that thoughtful, right minded reform is even possible given the entrenched and defendable position of participants.
I can’t think of many, if any, industries which have grown so huge and profitable (even if at taxpayers expense) where a sea change in regulation has been able to wrench back many years of evolution of industry practice. I think it is virtually impossible to take the banking industry back to the “relationship” days that your emailer yearns for.
I side with those who accept that red toothed, adversarial banking/trading is here to stay in one form or another – the better approach being to ring fence a utility banking system and let all participants decide in which sandbox they want to play. If you think the casino side still retains systemic risk the insulation hasn’t been done properly. And if participants choose to migrate to the utility side you will get your wish: selection will kill your banksters.
Point #4 is especially important.
Return to partnerships and watch the voracious appetite for risk melt away. Let them use reasonable leverage (how to determine that will be a real challenge) so long as they STRICTLY meet margin requirements at the end of each trading day – much like the major exchanges.
Returning to partnerships and forcing transparent pricing on public exchanges with all traded products (as noted in the piece) will solve a lot of problems.
Can I suggest a transaction tax linked to the holding time of the position?
Pretty straight forward really, but would hugely limit the gambling practises of major firms. If you want to invest for a few weeks, you pay no special tax.
A few minutes, you pay 50% of profit.
I kinda feel this would massively limit the ability to game the system.
I’ve done the math for this, let me know if you’d like to see it.
Sadly I agree with Andrew, it’s too late. However, I would go further. You government is completely captured by Wall Street, and mainly Goldman.
Chase the money lenders out or just get in line for the FEMA camps.
I really like #3 for some reason.
Mostly agree, except the fixation on exchanges/clearing houses.
First and foremost part of the banking system is to extend credit and take credit risk – for the commercial customers.
Exchanges/clearing/cash collateral should be mandatory for inter-bank transactions (and I think this is mostly true already).
Forcing commercial customers on the exchanges is BAD IDEA. Fullstop.
Requirement to post margin subject to volatility of a perfectly viable hedge position (say FX) can easily kill a corporate with not very good (but okish) cashflows – even though the hedge turns out to be in the money. Similar with IR swaps – if you were fixed-payer on and IRS in 2008, you’d get a huge margin call around late 2008 (with rates skyrocketing), even though the curve dropped dramatically just few months later.
Please, consider not only inter-bank trading (which is what most people seem to think about), but the commercials as well, and impact of regulations on these.
The liability issue is something I remember mentioning in comments on TBP about a year ago. I really think it’s at the heart of the problem. You can’t have a workable system where the worst that happens to a trader who loses millions of OPM is their job. Also, if we’re to bring back any old rule, it would be returning to the old model for auditors as well. Allowing them all to become LLPs paved the way for Enron, etc.
I should clarify – I never did buy the whole ‘rogue trader’ concept for either Barings in the 90s or that French (?) bank last year. If their managers really didn’t know what was going on, they should have and liability would certainly make them more vigilant.
That would be Societe Generale or SocGen for short.
Confidence in the Unknowable
The derivative traders are like the Cobol programmers of the last generation; they are being paid well to reside over their own funeral, as they are systematically culled from the system. Everything that cannot be marked to market is a sunk cost.
As far as Paul Volcker is concerned, he is fabricating the cleats to the American Enterprise System Memorial. Like the British Monarchy, such memorials provide something tangible for the older generations to hold on to, and guidance for the next generation of enterprise architects.
The cost of bringing along the values that withstand the test of time is bringing along examples of failure to invest in those values. The chain of empires is the DNA of human history.
The cleats are beefy because the new motor has to pull the entire chain, and AES will pull the rest of the chain intermittently, as the slack is pulled up. Everyone clinging to the old economy had better hope those cleats hold, because those are the ones that are going to get pulled on.
Paul Volcker is like the old man at the end of the pier everyday, with anglers telling him how to cast, decade after decade, when they have no idea what he is fishing for. The gold rushes come and go, but they never last. Few souls last the test of time.
As current history attests, the physicist at MIT is not the best physicist. The best physicist is the 12-year-old kid out in bum f—- North Dakota somewhere, with the greatest will to challenge current assumptions, and the God-given talent to surf the big current.
The best empire builders understand counterweight and false work. It’s one thing to study the wall; it’s another to get through it and live to tell the tale. Funny how kids can make something from nothing.
People have been trying to feed Volcker to the shark since the Great Depression. Good luck with that one. Tall Paul is betting on the kids, and heads I win, tails you lose with everyone else, while the shark circles their position.
Democracy has always resided in the hands of the children.
the bulk of the population now resides in the gravitational field, close to the fulcrum point, creating the nexus, and the kids are way out on the other end, in the magnetic field, balancing it.
the nexus is right up on top of the fulcrum mechanism, as far as it can go, and the gravitational side of the fulcrum lever keeps shrinking underneath it.
In order to peel the layers, and throw them to the shark below, long standing “contracts” have to be broken.
Joint and several liability does present a serious incentive toward being risk aware. Even with personal liability, however, we’ve had panics. In the days of partnerships the elimination of the profligate individuals and firms was accomplished in the bankruptcy court.
Personal liability, joint and several, can be established within the current structure. By itself, however it will stand incomplete. There is a second part that needs to be put in place and that is the very clear position that no firm or enterprise is too big to fail.
Now the rejoinder to NFTBTF is that the systemic interconnectedness of the market does not permit the orderly dissolution of a bankrupt. To that I observe: when a party abrogates a contract that abrogation exists as an actionable tort. Under certain circumstances the event may be a felony.
It is my view that the execution of a contract for which it is known that the contract cannot be honored is a fraud and that remedy for society is prosecution and incarceration.
I find the discussion offered here to be very helpful. There are a multitude of issues to be addressed. In the dialogue that is needed I think it is important to understand that you can’t go back to what was. It isn’t there any more. We must take what is and now alter and adapt it to what is needed.
The adage: as much as things change they remain the same, has application in terms of the principles upon which we need to consider the alterations necessary to our present circumstance. The terms and conditions of derivatives contracts are at their core straightforward.
I have yet to understand on and off balance sheet accounting. You either have an interest or you don’t. Now it may well be that your interest is contingent, nonetheless, you have an interest. In most of the mess we have at present that interest is a liability that cannot be met and most probably could not have been met at the date the contract was executed. These are considerations that are founded in principles and that is where our efforst at regulation should be focused. Principles based regulations coupled with specifically proscribed activity will serve us the best.
“Even with personal liability, however, we’ve had panics.”
And plenty of them – an excellent point you make. Much as I like the idea of partnerships instead of corporations, the historical evidence is clear that it won’t prevent panics. Plenty of people will get short term greedy even if their personal fortunes are at stake. There is no substitute for good regulation. Besides, we can’t put the corporation/partnership genie back in the bottle.
“I have yet to understand on and off balance sheet accounting.”
Same here. I’m not a finance person, but every time someone says “off balance sheet” it sounds like a euphemism for fraud.
“You either have an interest or you don’t.”
Exactly. Was it on this blog that someone claimed that the way accounting is done for insurance companies prevents this sort of nonsense?
I understand that “off balance sheet” is supposed to refer to things held in trust or managed by the firm, and not things for which they’re directly liable, but it sounds like vague definitions and supposed judgment calls are used to play a lot of games. How is this not fraud? Anyone familiar with this please elaborate.
‘3. Get rid of “mandated” rating agencies.’
The funny thing is, the rating agencies want to remove NRSRO designations too.
‘Instead encourage the use of more open source type rating agencies that actually published and allowed others to comment on the models and model assumptions that underly their ratings’
Really, you mean like the criteria, models and model assumptions we publish. You know there this thing call the internet, I think its a series of tubes or something, that has just that information you seek. Ohh also on the internet you will also find a Requests for Comment page some where in that series of tubes
Yves, I am not saying there is no room for reform of the rating agnecies, I am saying you dont know what you or your friend are talking about and you need to educate yourself. I am tired of these rating agency “experts” who dont even know basic facts. And if it could be fixed with two sentences, it would have.
I think ZH is now learning the limitations of its rating system. Betting on a dead horse to die doesn’t go very far, and becoming a market maker requires experience well beyond recognizing the problems with the old system.
Putting capital and ideas together, relationship management, to pull the load, especially when the load is 7 billion people, with many wanting something for nothing, in a millenium breeder reactor, is a little more complex than many assume.
Many have tried, and many have failed. Most then bet on system failure based on the experience, and increasing impatience. Persistence is the fundamental requirement, because challenging assumptions is the heavy lifting.
The system is not locked up because the parties want it to be locked up. The people got what they were bred to want, something for nothing, a market of promises.
The problems at the rating agencies are symptoms.
Yves has gotten much farther than others, and she appears to be persistent. Time will tell.
I have to say I see little practical difference between separating proprietary trading and customer service with eliminating off balance sheet transactions and increased transparency. If OBS were eliminated and with any reasonable degree of transparency, no one in their right mind would place their money with such an institution. The whole idea of OBS was to facilitate proprietary trading in complex instruments and obfuscate risk positions.
The same thing with capital and leverage – financial “innovation” was basically justification for high leverage – risk could be reduced via derived securities, blah, blah. Taxing complex transactions (which is fine in principle) basically eliminates their reason for being – decreasing their leverage and increasing capital requirements. Why not just segregate this at the institutional level?
Instead of strictly separating proprietary trading, there should be clear transparency and regulation in the relationships between the two, designed so that one can fail without risking the solvency of the other. If that design is impossible, then the two activities cannot be commingled.
Instead of figuring out variable capital, insurance, taxes, etc., instead just try to design how mortgages should be handled in principle. Should they be allowed to be pooled and tranched and resold? If not, you have to ask what kind of “innovation” do you expect the financial industry to create in the future? If so, then is there really any fundamental change being proposed?
I like the discussion of complexity and OBS. Complex OBS transactions are designed to avoid capital requirements and distort financial statements to the detriment of management, investors and ultimately taxpayers. Put a premium on them that is payable to the TBTF fund. Allow for financial innovation but then allow regulators to require more capital for those non-standard products.
As for compensation practices, claw-back through personal liability or in other modes should be an element but deferring compensation for a long enough period of time (e.g. 5 years) to allow bad deals to show themselves is probably easier. Clawing-back will involve litigation and/or administrative action and would be time-consuming. It’s better to have never given the compensation in the first place than to have fight to claw it back.
Not only did Marcel Ospel have no clue, and bought CDOs from US banksters in 2007, who already were shorting it, but his successor, Peter Kurer, joked in 2007! that nobody at UBS had any clue as to what CDS and CDO’s were! But that’s just Switzerland, a country more and more resembling an ‘Alice in Wonderland’ Wonderland, cut off from the realities of the real world.
Magi,
I suggest you look at Euromoney or Institutional Investor league tables. UBS was long ranked as one of the top derivatives dealers globally. This was most decidedly not the doings of a bunch of clueless private bankers.
The rating agencies, they are as reliable as those consumer reports/auto magazines. If I remember correctly, for years, they always had Toyota up there on safety and reliability.
Regarding point 2 an outright ban is unlikely. A variant of that idea, ban all OBS ACCOUNTING, might better serve the purpose. (See Frank Portnoy/Lynn Turner- Bring Transparency to OBS- From the Roosevelt Institute presentation- see links above- make markets be markets). Its a thoughtful piece and if the idea could be implemented it would undermine the key driver of ‘innovative’ product; obfuscation and complexity.
“Part of the problem is that as a society we need to balance the role of legitimate financial innovation with need for a robust system. Most binary solutions, such as Glass Stegall prohibitions do not adequately balance these important objectives.”
This is one of the current bankster smoke screens.
First, who’s “we”? Those of us out in Bitterland with jobs that depend on creating value instead of crumbcatching have provably never benefited from derivatives trading or any other exotic. This is a small handful of dealers negotiating minor advantages with large amounts of other peoples’ money.
Second, “legitimate financial innovation” packs a lot of falsehood into three little words. Real banking is a simple utility. There nothing new under the sun with deposits, loans, and forex. Creating paybacks dependent on abstruse math innovates nothing. Wagers are wager; they don’t deserve the term finance.
Indeed, leafing through my old Intro to Banking text, I’m struck that the only real new idea in banking in the last 100 years has been increasing government regulation and direction of the banks. That’s the innovation that has built the robust financial system that the traders are playing with. And strip mining.
OK, a lot of us, in fact, did see the size of the exposure. We couldn’t put a number on it because the precise information wasn’t (and isn’t) available, but we knew it to be large and systemically threatening. There was nothing difficult about this. The math was obviously and massively impossible.
I am a big backer of Glass-Steagall. Cutting commercial banking and insurance out of investment banking and confining them to vanilla products and activities reduces the scope of the problem by half. We also need to cut the investment banks off from government backstopping and lines of credit. This would make their getting credit from the shadow banking system considerably more expensive. And of course we can put restrictions on the shadow system, especially money markets as well.
Prop trading did not cause the meltdown but the philosophy behind it of putting the investment bank’s interests first was part and parcel of the securitization scheme to dump risk downstream and then bet against the bagholders.
This from “Questions and Answers about the Financial Crisis” authored by Gary Gorton on Feb 20th
“• As traditional banking became unprofitable in the 1980s, due to competition from, most
importantly, money market mutual funds and junk bonds, securitization developed. Regulation
Q that limited the interest rate on bank deposits was lifted, as well. Bank funding became much
more expensive. Banks could no longer afford to hold passive cash flows on their balance
sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system.
Securitization became sizable.
• The amount of money under management by institutional investors has grown enormously.
These investors and non‐financial firms have a need for a short‐term, safe, interest‐earning,
transaction account like demand deposits: repo. Repo also grew enormously, and came to use
securitization as an important source of collateral.
• Repo is money. It was counted in M3 by the Federal Reserve System, until M3 was discontinued
in 2006. But, like other privately‐created bank money, it is vulnerable to a shock, which may
cause depositors to rationally withdraw en masse, an event which the banking system – in this
case the shadow banking system—cannot withstand alone. Forced by the withdrawals to sell
assets, bond prices plummeted and firms failed or were bailed out with government money.
• In a bank panic, banks are forced to sell assets, which causes prices to go down, reflecting the
large amounts being dumped on the market. Fire sales cause losses. The fundamentals of
subprime were not bad enough by themselves to have created trillions in losses globally. The
mechanism of the panic triggers the fire sales. As a matter of policy, such firm failures should
not be caused by fire sales.
• The crisis was not a one‐time, unique, event. The problem is structural. The explanation for the
crisis lies in the structure of private transaction securities that are created by banks. This
structure, while very important for the economy, is subject to periodic panics if there are shocks
that cause concerns about counterparty default. There have been banking panics throughout
U.S. history, with private bank notes, with demand deposits, and now with repo. The economy
needs banks and banking. But bank liabilities have a vulnerability.”
capital wants it both ways. it wants to set objective-based goals, with no idea how to implement them practically, and, at the same time, wants to micromanage labor, running the same algorithm over and over, placing accounting walls between labor, both vertically and horizontally, with call centers to collect data, cookie-cutter enterprise systems to analyze the data, and PLC architecture to implement policy, with nye a single firing of a neural synapse anywhere.
as a result, a thick layer of middle managers have invested all kinds of time, only to find themselves processing the wealth transfer system, and temporarily renting their lives, until the next row of teeth are grown in the shark’s mouth. they can go forward only so far, and they cannot go backwards.
because symbiotic systems are inherently reductive in nature, constantly recycling vestiges back into basic building blocks for re-introduction into the circuit, the nexus, which refuses to disassemble, is increasingly pressurized, and as it continues to refuse disassembly, the possible sources of relief, the valves are eliminated.
of course the nexus wants to inch up incrementally; that’s its nature, but it is already sitting atop the fulcrum mechanism now. it can only go so far forward, and it cannot go back. the nexus is locked into a catch-22 trap by its own psychology.
left to their own internal processes, the global cartels have neither access to the scientific method, nor the inherent psychology to contemplate anything beyond their own structure. watching someone else work, and writing a program/law is one thing; actually doing the work is another.
yes, the cartels are big, and they are nasty, but they cannot learn. They have been reproducing themselves for several thousand years, as the counterweight. They are the proton, and they are measurable. What their size tells you is the voltage potential of the electrons, which cannot be measured directly.
The problem is not a function of coming up with a great idea, or a new law; it is a function of establishing the circuit, which may be done in an infinite number of ways.
It’s like cleaning up a kitchen after a big party. It’s hard to establish the organization before you get your hands dirty, and pretty soon thereafter, everyone skating in the direction of completion finds themselves invited to the next party.
Do any of you understand Our Congress People have been CAPTURED by the Bankers/Financial Industry and they(Clowngress) will do NOTHING to Their Owners ! ! That IS the way it IS! ! GET OVER IT ! ! WE can do nothing – the US$ Will IMPLODE………tick…tick….tick………..
You’re getting close. The fundamental problem is that the US Corporation is run by executives for executives, insulated from liability.
General Partnerships would be great. If they’re going to have limited liability corporations, the stockholders have to have actual control over the companies, as it’s simply the only way to prevent the execs from simply enriching themselves. This means as a first step commonsense shareholder democracy reforms which the SEC has already proposed (and which the criminal CEO class is fighting). Subsidiary requirements: it should be illegal for corporations to vote stock they own, this should be the right of the stockholders.
This is universal to the corporate sector. This is why I practically only invest in family-owned companies now.
In finance, this is really a matter of reserve requirements — requiring banks to hold large hunks of deposits physically in the vaults. That is the *only* way to prevent excess speculation.