A very interesting article by the Economist Intelligence Unit (EIU) I thought was worth sharing:
The US$2bn loss saddled on UBS by a suspected "rogue trader"
is a reminder of investment banks' awesome capacity to both create and,
more recently, destroy wealth. As their lobbying against reform loses
sway, banks must either accept higher costs commensurate with the risks
they generate or shun racy wholesale franchises and focus on the
stodgier, but safer, functions of the industry.
Three
years after the collapse of Lehman Brothers, the risks inherent in high
finance appear undiminished. An apparent "rogue trader" at UBS, alleged
to be 31-year-old Kweku Adoboli, will saddle the Swiss bank with a
US$2bn loss, according to a company statement on September 15th (the
three-year anniversary of Lehman's bankruptcy). Although the loss will
not threaten the bank's solvency, it is enough to wipe out its
third-quarter profits. More importantly, it is an untimely setback for
the banking industry as a whole; the sector's largest players are
fighting against reforms on several fronts. Their lobbying influence is
likely to wane as official attitudes harden on taxpayer support for
banking groups that feature both risky wholesale units and less
hazardous retail businesses.
Mr Adoboli's backstory is
depressingly familiar. In fact, his CV reads remarkably like that of
Jerome Kerviel, the rogue trader who, at 31, cost French bank Société
Générale the equivalent of US$7bn in unauthorised trades in 2008. Both
Mr Kerviel and Mr Adoboli began their careers in the back office before
moving into trading for the "Delta One" desks at their respective banks.
Delta One units trade a wide range of securities in order to replicate
the performance of benchmark assets in exchange-traded funds (ETFs) or
swaps (using derivatives to track the performance of copper instead of
buying the commodity itself, for example).
This flexibility could
make these particular units more prone to disaster, and traders with
intimate knowledge of back-office compliance procedures may be more
inclined to skirt the rules on building up dangerously risky positions.
UBS's unauthorised trades, for example, appeared to conform with "the
normal business flows of a large global equity trading house as part of a
properly hedged portfolio", the bank said in a statement on September
18th (which also boosted the estimated loss on the trades to US$2.3bn). A
series of "fictitious, forward-settling, cash ETF positions" masked the
positions by making them appear hedged, the bank added.
For
UBS, the Kerviel-esque trading scandal is particularly damaging in
light of the contrition shown by the bank following the loss of some
US$50bn during the financial crisis and a subsequent bail-out by the
Swiss government (see chart). The pledges to boost internal controls and
tighten risk-management procedures now ring hollow. Strict new capital
requirements introduced by the Swiss last year could be strengthened
further, and UBS's underperforming investment bank will come under even
closer scrutiny by regulators; assets at the investment banking unit are
almost twice Switzerland's GDP.
Sound and fury
More
broadly, the UBS affair is a fillip for supporters of sweeping
regulatory reforms, and not only in Switzerland. The Basel III
international capital accords, the Dodd-Frank Act in the US and the
recommendations of the Vickers commission in the UK all represent major
overhauls of banking regulation and oversight, and all are the subject
of furious lobbying by banks.
The banks' arguments, in essence,
are that the new rules will throttle lending, depress returns and,
ultimately, harm economic growth. But the uncomfortable regularity with
which investment banks are prone to costly stumbles make the claims of
banks with large wholesale arms lose much of their authority.
Goldman
Sachs settled a case with the US securities regulator last year, for
US$550m, in which the bank was accused of fraud related to the creation
of subprime mortgage-backed securities. Fabrice Tourre, a 31-year-old
middle manager at Goldman Sachs, played a prominent role in the suit,
and is still fighting civil charges brought by the regulator. Like Mr
Kerviel before him and Mr Adoboli after him, the prominence of Mr Tourre
fits an established pattern. But the investment banking industry's
problems run deeper than rogue thirty-somethings.
In the summer of
2007, when the first signs of a credit crunch emerged, many investment
banks blamed bad luck for poor performance. David Viniar, chief
financial officer of Goldman Sachs, famously cited "seeing things that
were 25-standard deviation moves, several days in a row". In a withering
paper examining this assertion, a group of professors led by Kevin Dowd
of the Nottingham University Business School revealed that a six-sigma
event suggests an occurrence of "less than one day in the entire period
since our species, Homo Sapiens, evolved from earlier primates". A
25-sigma event, therefore, features a vanishingly small probability best
measured on "cosmological scales", they concluded.
Fighting back
Is
the welter of new regulations now looming over investment banks yet
another bout of bad luck? In isolation, the new rules introduced by
Basel III, Dodd-Frank and other reform efforts will depress the average
return on equity at large investment banks from 20% in 2010 to only 7%
after implementation, according to McKinsey, a consultancy. At the group
level, big banking groups will need to cut costs by 6% and at least
double profits every year for five years to earn their cost of capital,
it says.
Understandably, banks are lobbying against key aspects of
regulatory reforms, even as they acknowledge that the pre-crisis status
quo is untenable. The Institute of International Finance, a banking
industry association, published a report earlier this month that claimed
financial reforms would subtract 0.7% from GDP every year through 2015,
resulting in 7.5m fewer jobs over that period than should otherwise be
expected. "It is important to guard against allowing excessive risk
aversion to act as a brake on prudent credit expansion", the institute
said. Similar objections are raised in relation to the ban on
proprietary trading the so-called "Volcker Rule", currently being
finalised as part of Dodd-Frank's implementation in the US as well as
the proposal for erecting a ring-fence around the retail units of
universal banks in the UK. Jamie Dimon, chief executive of JPMorgan
Chase, took a different tack with recent criticism, calling the Basel
III rules "blatantly anti-American" in an interview with the Financial Times.
Whatever
the merits of these objections, and even if recent losses are down
purely to lousy luck or relentless rogues, - a big if - the industry's
frequent missteps will spur officials to err on the side of stricter
rules. Witness the recent momentum for a financial transactions tax in
the European Union, a measure with questionable merits as a tool to
prevent future financial crises but a clear impact on the profitability
of banks' capital-markets activities. A similarly stern approach should
be expected when it comes to rules that have been passed but remain
subject to interpretation ahead of future implementation, namely Basel
III and Dodd-Frank.
Separation anxiety
In
unveiling the proposals for a ring-fencing of retail banking in the UK,
Sir John Vickers stressed that, "the 'too big to fail' problem must not
be recast as a 'too delicate to reform' problem." By most accounts,
third-quarter results from the developed world's leading banks will be
disappointing. A spate of banking layoff announcements in recent weeks
underscores the industry's fragility. But whereas previous bouts of
banking weakness generated sympathy - and in some cases, action - among
officials, similar support will be less forthcoming in the future.
Thanks
to new regulations, funding costs for investment banks are likely to
settle at a permanently higher plateau than before the financial crisis,
reflecting the risks inherent in these businesses as well as the
removal of implicit taxpayer support for so-called "casino" banking
operations. Returns will fall accordingly. Banks still have significant
scope to cut compensation costs in order to bolster their earnings,
rather than curtail lending or hike interest rates; business loans,
after all, account for only around 10-15% of banking assets in the US
and Europe.
The competence of investment banks is also back in the
spotlight following UBS's revelations. Recent innovations in the ETF
industry - once the domain of passive, low-cost index trackers - recall the
dangerous complexity that blossomed in mortgage-backed securities before
the financial crisis. Investigations into the risks of synthetic ETFs
that are the lifeblood of Delta One desks were already underway in
several jurisdictions before UBS's announcement. An industry that argues
for flexibility in new regulations, and yet is gaining form when it
comes to both creating and mismanaging complexity, will find that its
appeals carry less authority than in the past.