“Summer” Rerun: Why Big Capital Markets Players Are Unmanageable

This post first appeared on July 8, 2009

John Kay comes perilously close to nailing a key issue in his current Financial Times comment, “Our banks are beyond the control of mere mortal” in that he very clearly articulates the problem very well but then draws the wrong conclusion:

At Oxford university, I often hear people say there is nothing wrong with the system: the problem is the vice-chancellor/master/bursar/ university officials. And, in a sense, they are right. If the vice-chancellor had the wisdom of Socrates, the political skills of Machiavelli and the leadership qualities of Winston Churchill, not to mention the patience of Job, he or she would be very likely to be able to fulfil the conflicting demands of the post. But such paragons are few and far between. In the meantime we must try to find structures that can be operated by ordinary mortals.

In the same way, the claim that the fault with the banking system lies not with the structure of banks but with the boards and executives that claimed to run them is both correct and absurd…if the failures are both as widespread and as persistent as it appears, the problem is in the job specification rather than with the incumbent. If you employ an alchemist who fails to turn base metal into gold, the alchemist is certainly a fool and a fraud but the greater fool is the patron.

The bank executives pilloried by the UK’s Treasury select committee of MPs were all exceptional people. The vilified Sir Fred Goodwin was an effective manager who had slashed through the National Westminster bureaucracy and revived a failing institution – a task that had defeated many able men before him. His chairman, Sir Tom McKillop, offered experience and ability that met every possible specification for such a role in a big international corporation. As chairman of HBOS, Lord Stevenson was Britain’s supreme networker. This skill is a particularly valuable attribute in an environment where the essence of banking is to extract very large sums of taxpayers’ money while giving as little as possible in return. His chief executive, Andy Hornby, was criticised for being a retailer. But Halifax, half of HBOS, needed retail expertise. The only thing it needed to know about complex securitised products was that there was no good reason to buy them.

Like Sir Fred, Sir Tom, Lord Stevenson and Mr Hornby, most of the people who sat on the boards of failed banks were individuals whose services other companies would have been delighted to attract…

The hapless four were criticised for their lack of banking expertise but it is, in fact, not clear what modern banking expertise is. The world of modern banking requires all the skills of these gentlemen, plus some others, and no one can expect to have all these attributes.

It has been said of Jamie Dimon (who does not have a banking qualification) that his dominance exists because at every meeting all the participants know that he could do each of their jobs better than they could. But the business world cannot operate at all if it can operate only with individuals of the calibre of Mr Dimon. Better, as so often, to follow an aphorism of Warren Buffett’s: invest only in businesses that an idiot can run, because sooner or later an idiot will.

Our banks were not run by idiots. They were run by able men who were out of their depth. If their aspirations were beyond their capacity it is because they were probably beyond anyone’s capacity. We could continue the search for Superman or Superwoman. But we would be wiser to look for a simpler world, more resilient to human error and the inevitable misjudgments. Great and enduringly successful organisations are not stages on which geniuses can strut. They are structures that make the most of the ordinary talents of ordinary people.

The problem is Kay is applying traditional managements structures to investment banking, Even though these entities may have substantial retail arms and bank charters, the area that poses the management challenge is the capital markets businesses. And he makes a dangerous, erroneous assumptions: that mere mortals, meaning generalists, can run these businesses. That is bogus.

What makes capital markets businesses different from any other form of enterprise I can think of is the amount of discretion given of necessity to non-managerial employees, meaning traders, salesmen, investment bankers, analysts. In pretty much any other large scale business, decisions that have a meaningful bottom line impact (pricing, new sales campaign, investment decision) are deliberate affairs, ultimately decided at a reasonably senior level. The discretion that customer-facing staff have in pretty much any business in limited. At what level does someone have the authority to negotiate a contract? And even then, how many degrees of freedom do they have?

By contrast, think how many decisions traders and salesmen in capital market firms make in a day, and their potential bottom line impact (though experiment: how much damage could a truly vindictive trader do in a day or a week, if he decided to blow up his employer?) Investment bankers work over longer time frames, and like many normal businesses, have a lot of things routinized so as to make them more efficient, but it also limits their latitude (standard forms for many types of client agreements, standard pitch book formats, etc). However, unlike “normal” businesses, a frequent activity in investment banking is creating new products, often in a very ad-hoc way, with teams with relevant skills thrown together to try to push something through. The politics are often sharp-elbowed, but people are too pragmatic to let turf issues interfere with getting a new deal launched).

The approach for managing these businesses in the days of partnerships, when the owners were personally liable for losses, was to have small units with partners running them who knew the business and could oversee it properly. Effectively you had four layers: associate/analyst (the college kids, the analysts, did pretty much the same stuff the associates did, who usually had MBAs, except the MBAs got to go to client meetings more often), VPs, and partners, but some of the more senior partners were department heads in units that also had partners (who’d manage either people on their desks, if traders of salesmen, or if in investment banking, had accounts and various VPs and associate types working on each client). But those department heads had also grown up in the business, and were still active in it. Heads of significant departments in turn would be on an executive committee, a part-time role.

The problem with this model is it starts to come under strain when the partner group gets too large. And OTC markets have strong network effects, so having bigger market share confers a competitive advantage. And now there are high minimum scale requirements for being in the business. You need to be in all major times zones with a pretty broad product array. all kinds of back office support, all kinds of IT for risk management, communications, position management…

So the scale of operation required to be competitive is too large for it to be managed by player-coaches who had deep expertise, and like the Dimon example, were more expert than the people working for them. But the normal corporate/commercial banking management structure, with more managerial layers, and the top brass having broader spans of control, was devised in earlier stages of industrial organization, when you had factories or service business with a great deal of routinization of worker and middle manager tasks. Traditional commercial banks are on the same factory format. They handle large volumes of very simple, standard transactions with a high degree of control and oversight. That’s a big reason why it took commercial banks over 15 years to make meaningful headway against investment banks. Although regulations were an issue, the bigger barrier was the radical difference between the two management cultures. There was no regulatory barrier to commercial banks offering mergers & acquisitions, for instance, but they were lousy at that for a very long time.

So Kay is effectively asking for a traditional commercial banking model, businesses “that make the most of the ordinary talents of ordinary people”. There are businesses like that in banking, but they are mainly in retail banking and corporate lending. If you want that world, you need a far more radical change in the industry than anyone is contemplating now. You’d need to go to the world that Taleb advocates, From a list of his ten suggestions:

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

If we can’t shut down credit default swaps, which the more I dig, the more I see they had a very direct role in the meltdown CDS on subrprime mortgages started in 2004, and there is a longer form gloss as to how that played a major role, if not the key role, in the superheated demand for “product” particularly subprime, in the manic phase of the credit bubble), we will never get to a world like the one Kay wants to see, or at least not until we hopelessly break the one we have now.

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  1. F. Beard

    … adding debt produces wild and dangerous gyrations and leaves no room for error. John Kay

    What debt? The banks create money as they lend. If money creation is a dangerous power in the hands of government it is worse in the case of banks since the banks lend, not spend, their money into circulation thus adding the danger of deflation to the theft by inflation. There is also the impossible contract problem since the interest must be created (sans government deficit spending) by lending too.

    Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious. John Kay [bold added]

    Capitalism based on usury alone is unstable according to Karl Denninger because the debt normally compounds faster than real economic growth. But who needs usury? Common stock is a usury-free money form. But that would involve “sharing” wealth and power and we can’t have that, can we? :)

  2. skippy

    How do you defuse – financial EOD if you will, that which could more likely than not, be a bunch of contracts that in reality ( accounting ), define the term zero price and value.

    Skippy… Gawds work, I get it now, contracts of belief.

  3. Cathryn Mataga

    CDS is the thing that lies to bankers, that tells them that the risk is less than it really is. As a result banks take on even greater risks.

    When those risks inevitably explode, banks go to governments for rescue. To pay for the bank rescue, governments inflict austerity on the people.

    Financial innovation did what Karl Marx and the USSR tried and failed to do. It killed capitalism.

    1. F. Beard

      Financial innovation did what Karl Marx and the USSR tried and failed to do. It killed capitalism. Cathryn Mataga

      Cute! But the truth is that fascism was given enough rope and it finally hung itself.

      Btw, I recommend the movie “Margin Call”. I now have less respect but more sympathy for Wall Street traders.

      The Arragement – Joni Mitchell

  4. Ignacio

    Yves, I believe that you misinterpretated Kay. I think that the author of the article is trying to argue is that proper laws and regulation would make it easier not only bank management but also government in a way that ordinary people could do a good job.

    I think it is a desperate call for a deep reform not only in the finantial bussiness but in the whole society. The question is ¿what reform?

    Anycase thanks for bringing this article and for your arguments.

    1. Ignacio

      Forgot to write that many of yours and Taleb’s suggestions look sound to me. Talking about complexity it strikes to me a recent article written by S.R Waldman in interfluidity asking why finance is so complex. He writes about the need of opacity in the finantial system needed for the system to work. Probably, the CDS market acts as a window of publicly available information that should be kept secret in order to avoid so many people speculating on companies and countries defaulting.

  5. Ransome

    I was under the impression that CDS on subprime started in 2005, when Burry wanted to short the fraud in the system although he probably didn’t know it was fraud at the time. When he went looking for a broker dealer to set up CDS shorts. At first, no one knew what he was talking about, but they were quick studies. It was a few months later that the securitization of subprime took an abrupt nose-dive, with F&F plunging along, oblivious to the change in the weather. It was just this time that Mudd went hat in hand to Mozilo looking for more business and Mozilo just happened to have a truck load of ALT-A no one wanted.

    I don’t find Kay’s viewpoint inconsistent with the author. Look at the Fed, it is becoming a one man performance. Replace Bernanke with Fisher and likely a different approach will emerge. Do we need dramatically different approaches in managing the money supply? It is becoming more clear that as the money supply increases, it is less efficiently managed, creating bad behaviors until collapse. Dimon may be bright but he is very dangerous. Any idiot can run a McDonalds because the franchise has been developed to be run by idiots, as long as you work hard and don’t deviate from the franchise rules and SOP’s.

    Sir Tom had experience but he began life as a bench chemist and had the fatal flaw of most scientists, they trust people. Trust is fatal in the world of broker-dealer banksters because every minute of the day, they are trying to convince Marks to take actions that will be disadvantageous to themselves, a point which Taleb acknowledges. It is a confidence game and Dimon is a master. Didn’t he convince the President that there is no difference between a broker-dealer bankster and a highly paid athlete? Kay wants to take managing the distribution of money out of the hands of too clever people and certainly out of the hands of the confidence men. It must be done.

    Somehow we will need to discover methods to measure when there is too much capital in the system, that promotes bad behavior; also a method to measure how efficiently capital and labor are being used and what the ratios and volumes of distribution of capital and labor. As much as we talk about the ideal of knowledge worker jobs, there must exist a large number of semi-skilled positions. There are people that will be pleased to be at the top of their game when they own a small business mowing lawns.

  6. groo

    I keep John Kay in high regard and read his column regularly.

    so I’m thrown between John’s and Yves’ position on that.

    I did some heavy stock/derivatives trading during the dotcom-bubble years with my OWN money, and always have been a contrarian, which means I saw the bubble unfolding, just like the housing bubble, which started to unfold in the beginning of 2007. You can study this on the indices post mortem.
    (Not that I made a lot of money on that. If you are too much out of sync of common idiocy, You dont profit much.
    At least I survived. Lucky me.
    Since 2002, I was only watching, diagnosing, analyzing this monster, which we call the ‘financial market’.)

    What I learned from that, was, that the marketmakers, GS etc, are outright frauds, through the bank, so to say.
    Two examples:
    1) Broadcom stock pushed up 30% during some five hours.
    2) Sycamore Networks at its had a stock value which amounted to a desk out of pure gold for every employee, which one could quickly calculate.(gold was cheaper then)
    But this did not make the absurdity go away.
    The reasoning seems to be: “Well this is absurd, but when it is absurd, why not make it even more absurd?”
    One cause is structural information asymmetry. The market-maker always knows more than the mere market-participant.
    Then add some decent dose of testosterone, and here we are.

    The upper echelons in the banking hierarchy are lost in their own abstractions, i.e. the overall profit this absurdity made for bank as a whole.

    Here we are deep in Akerlof’s “markets for lemons” territory, as Bill Black repeatedly notes in other contexts.

    There is a point in time, when the lemons are too dominant, that there is no rescue, and the whole edifice has to collapse.

    The traders themselves know that quite early, but do it anyway, because the evolution of the whole edifice drives the good apples, who have a residuum of a moral compass, out of the system.

    The chiefs willfully ignore this behavior, because they compete with other chiefs on the abstract overall profit-level of their corporation.

    I have no recipe for curing that, other than let them fail (wont), put them in jail (wont), chop their heads off (well, this is an unwelcome outcome and throws us back into the middle ages)

    All I can see, is, that this is
    a) an ethical disaster (value, trust, respect…)
    b) a structural disaster (hierarchy)
    c) a disaster of our mode of reasoning (lost in abstraction)

    John and Yves suggest different diagnoses to the same disease.

    I put my hat into the ring with my interpretation, which is combining them and add a bit of spice.

    1. groo


      To recognize the inherent limit of John Kay’s thinking, visit his ‘about’-page: http://www.johnkay.com/about

      Thinkers can only be appreciated by their backgrounds.
      “Das Sein bestimmt das Bewusstsein” (Marx)
      –> “The mode of Being defines what you think”

      We -hopefully- have some tools recovering from that.
      EG reflecting, as a group.

  7. Susan the other

    Commercial complexity is itself a form of leverage, an efficiency, which provides an edge for success? And all the efficiencies created by complex financial transactions also serve to lever success usually by hedging risk? And in so doing they just spread all the possibilities for both success and failure in a widening circle? And at some point when both efficiency and complexity have reached their limit, the whole levered system cannot take one more debt obligation because when the risk is gone the profit is also gone. And instead of a small collapse we have doozie? And the poster child for this process is a financial instrument so arcane that only the Jamie Dimons understand it? A Credit Default Swap. Because there was no limit on how many of these “contracts” could be written nor what they could cover. I think insurance is just another form of religion – as someone above quipped – indulgences.

    Is it possible that the thing that has stopped growth is not the huge debt burden, but the huge insurance burden?

  8. groo

    … And at some point when both efficiency and complexity have reached their limit, …

    ‘Complexity’ and ‘Efficiency are difficult abstractions.

    I restrain from ‘complexity’ right now.
    if You like, I deconstruct that, but will take me some time.

    ‘Efficiency’ is comparatively simple, in that it begs the question in itsef:
    W.R.T what?
    The GOAL is the message, to paraphrase the good Mr Luhan.

    1. groo

      to repeat
      “efficiency” is an attribute, which is glued onto some subject, and above that some goal.
      so lets practice that
      “I efficiently pursue to be the master of the universe.”
      (Think Kurzweil)
      “I” : the subject of pursuance.
      “The master of the universe”: The goal which the ‘subject’ tries to transform itself into.

      ‘Efficiency’ is the set of tools to transform the ‘I’ into its goal in the most efficient manner.

      Think Blankfein, Kurzweil and his likes.

      The rest of the world is just a tool for this transformation.
      There are a lot of minions of this ilk, eg Robin Hanson: http://www.overcomingbias.com/
      Or poor Katja, as I call her:

      You will not notice that at first sight.

      They seem to be quite reasonable, but upon thinking about them for some time, it gets spooky, to say the least.

  9. Blissex

    The analysis by McKay seems to me completely wrong because it is based on what seems to me a deliberate misrepresentation of the role of a CEO or Chairman or a large diversified financial intermediary, which is to act as venture capitalists, that is to do strategy as to capital deployment.

    He instead tries to argue that their role is to run the business, which is ridiculous.

    As strategic venture capitalists, Sir Goodwin and the other failed spectacularly: they invested all the capital of their businesses in extremely risk high leverage business lines instead of shutting them down. They also colossally mismanaged the very capital structure of their businesses by making it so it would amplify problems instead of dampening them.

    They could have instead followed the Buffett rule of not investing in businesses they did not fully understand. If Buffett does it, I guess Sir Goodwin and other very smart people could have done it as well.

    Presumably they poured all their capital into mad fun business because they wanted to goose returns as high as they could while things were good, safe in the knowledge that when things would go bad they would still have life-changing wealth and the government would bail out the business in their role of donor of first resort.

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