John Dizard, who perhaps by virtue of being one of the Financial Times’ most original and insightful columnists, is relegated to its weekend “Wealth” section, has written a particularly important pair of articles. Note that Dizard’s ambit is not policy wonkery but apt and often cynical observations about behavior and trading patterns in less visible part of the financial markets, and sometimes the spending habits of the uber-rich themselves, and what they portend for investments and the economy.
The week before last, Dizard penned an important piece, In the shadow of quantitative easing, party like it is 1788, in which he pointed out that the meant-to-be-stealthy part of the bank bailouts, ZIRP and quantitative easing, had served to shift the risk of the next crisis off the regulated parts of the financial system and onto investors, particularly long-term investors like life insurers and pension funds. His piece last weekend, The US financial industry should listen to leftwing reformers, builds on his observations about where risks sit to argue that the financial services industry would do far better to listen to critics and go back to a clearer separation between commercial banking and trading activities* than we have now.
Dizard chooses to depict the case for breaking up big banks as a pinko argument, when the Bank of England has also fought fiercely for it; it had to settle for ring-fencing because the UK Treasury campaigned hard. And the arguments that the Bank of England made are sound. For instance, Andrew Haldane has pointed out that one of the results of deregulation has been homogeneity in strategies, and even in how banks model risk, ranging from approaches like VaR to the pervasive use of FICO in the US. The result resembles an ecological system with a dominant species. They are much more prone to collapse than ones with more diversity.
I’m in favor of Glass-Steagall type reforms too, but for different reasons. I’ve regarded from my very first days working with commercial banks (and that was Citibank in the early 1980s, meaning a top player at the time) that the managerial requirements for investment banks and commercial banks are diametrically opposed. And what has developed over time is a Rube Goldbergian compromise which results in the worst of all possible worlds (well, save for the inmates): it leaves the foxes, as in the “producers” running the henhouse, with the nominal leaders of these organizations regularly pleading ignorance as to the fact that there is gambling taking place in their ranks.
Here are the key sections from the first leg of Dizard’s argument:
As the promises to pension, life insurance and guaranteed investment contract beneficiaries are discounted at very low or negative rates, they eat through any reserves or capital the institutions have on hand. At the same time, the institutions earn less and less income from any new securities purchases. This has happened slowly, and, with the curve bending downwards in working populations, quickly.
Someone will have to explain to the pensioners and survivors that they are not getting what they are promised. I would suggest not applying for that particular job opening. The compensation for investment managers who are arithmetically certain to lose money will tend to decline over time.
When someone says I am not smart enough to understand persistent negative real rates (the “persistent” is important), I have to agree. There is no way I could project all the dreadful consequences. However, it would be difficult to match the stupidity of the excuses for the current consensus on central bank policy….
To their credit, Federal Reserve staff seem quite guileless about the shortcomings of the long-term projections generated by their central model.
Not that the market people are without their sins of oversimplification and formalism. They have stretched VAR models for risk far beyond their real utility. The market’s risk managers have the same motivation as the macroeconomists: their bosses want a short answer that supports their compensation plan or political platform.
Let us not put too fine a point on this: even though Dizard is talking about the impact on institutional investors, the parties that will take these investment shortfalls in the chin are life insurance policy-holders and pension fund beneficiaries, meaning individuals.
Now to Dizard’s defense of Glass-Steagall 2.0:
The US financial industry should accept the leftwing reformers’ demand to reinstate what is called the Glass-Steagall act…
So why should Wall Street go along with the demands of politicians such as Senator Bernie Sanders and Senator Elizabeth Warren, who do not even have control over the Democratic party? Because in the next crisis, the large banks and securities dealers will need a bailout not so much for themselves as for their customers.
Executives of big banks have already warned that their institutions will not even be able to accept more flight-to-safety deposits in a crisis, let alone extend much more credit.
In JPMorgan’s annual report to shareholders, chief executive Jamie Dimon wrote: “It is my belief that in a crisis environment, non-bank lenders will not continue rolling over loans or extending new credit except at exorbitant prices that take advantage of the crisis situation. Banks knew that they had to lend freely because effectively they are the ‘lender of last resort’ to their clients as the Federal Reserve is to the banks.”
Dizard uses the fact that Bernie Sanders’ plan to break up the banks is so thin as to be unrealistic to argue that banks need to embrace the need to radically restructure themselves rather than have solutions foisted upon them:
After all, in many ways, banks’ participation in the capital markets business is no longer so attractive. In still-liquid markets, dealing spreads have been arbitraged away by an excessive number and capital weight of participants. In illiquid markets, such as junk corporate credit, it is very difficult to do appropriate risk management.
Bank compliance culture has become so elaborate and impenetrable that traders are unable and unwilling to provide bids and offers. They do not want any echoes of Ms Warren’s recent comment that “I never hear the case why it is that some investment bank that wants to take risks on Wall Street, and wants those kinds of profits, should have access to your grandmother’s checking account”.
The only way to really end this sort of talk is by completely separating the capital structures, managements, directors, personnel and even premises of commercial and investment banking. That may be an immediate expense for the shareholders and the economy, but it is better than the possible alternatives.
As I indicated earlier, I’m in favor of Glass-Steagall type reforms, but have not pushed them hard because I don’t regard them at the top priority in addressing what ails our financial system. As Richard Bookstaber pointed out in his landmark book, A Demon of Our Own Design, tightly-coupled systems, meaning ones where processes can be triggered that move too quickly for humans to interrupt them, are failure prone. The most important step in dealing with a tightly-coupled system is to undo or reduce the tight coupling first. Taking other risk-reduction measures before you’ve reduced the tight coupling will increase, not decrease, risk.
That means the first orders of business are reducing the amount of over-the-counter derivatives (much of which has been shifted to the shadow banking system, often investors themselves) and getting rid of high-frequency trading, which serves no socially useful purpose** and increases systemic risk.
As for the managerial issues, traditional commercial banking (think retail branches) involves having a large number of staff perform activities with a high degree of routinization, a very high degree of accuracy, and strict controls. Think of branch tellers, or check and credit card processing, which in the stone ages of banking, was done manually!
Managers in banks tended to rise based on time in grade, and one’s power was strongly correlated with how large a span of operations you controlled. Crudely speaking, the more powerful managers oversaw more people. New product introduction was a deliberate affair, since any “innovation” would be rolled out across the relevant business units in a uniform manner. Thus management was also top-low, with many layers in the hierarchy and lower-level staff having very little discretion.
By contrast, power in investment banking is all about profits. Small units like Goldman’s risk arbitrage department under Bob Rubin were highly influential by virtue of how much they generated. Unlike bank managers, partners oversaw very narrow businesses, typically ones they had grown up in and had even built. Hierarchies in investment banks were flat, and junior people interacted regularly with partners. And “talented” people were promoted quickly. The idea of time-in-grade was anathema to investment banks.
But as investment banks and commercial banks started becoming more or less the same thing, the merging of the two managerial models produced what Occupy Wall Street has correctly called too complex to oversee. From ECONNED:
On paper, capital markets enterprises look like a great opportunity. The firms that are at the nexus of global money flows participate in a very high level of transactions. Enough of them are in complex products or not deeply liquid markets so as to allow firms to find ways to uncover and in many cases create and seize profit opportunities. New, typically sophisticated products often provide particularly juicy returns to the intermediary. And in theory, clever, adaptive, narrowly skilled staff can stay enough ahead of the game so that the amount captured off this huge transaction flow is handsome.
Once again, however, the real world deviates in important respects from the fantasy. Why? This business model is also a managerial nightmare. We have a paradox: “success” and profitability in the investment banking context entails giving broad discretion to individuals with highly specialized know-how. But the businesses have outgrown the ability to monitor and manage these specialists effectively. The high frequency, meaningful stakes, and large absolute number of decisions made at the operational level, the geographic span of these firms, and the often imperfectly understood interconnections among business risks make effective supervision well-nigh impossible.
In other words, while it is wonderfully convenient for CEOs like Lloyd Blankfein and Jamie Dimon to profess that they didn’t know about chicanery that took place on their watch, the reality is it would be very difficult for them to keep an adequate rein on their sprawling, complex businesses even if they wanted to. And that makes it even more important to chop these organizations down to sizes that their putative leaders could conceivably control.
* Keep in mind that an absolute separation is neither practical nor desirable. Banks (like major coporations) have large treasury units which managed the bank’s own cash inflows and outflows. That means that inevitably that a bank will be engaged in trading if nothing else to manage its own money markets and foreign exchange operations. FX rates key off interest rate differentials between in money market instruments in various currencies, so an FX trader benefits from, indeed one can argue needs to trade Treasuries and other major sovereign bonds. Thus there is a bit of thinking that needs to go into how best to draw the line between commercial banking and securities trading, particularly since so much in the way of traditional banking has been moved into capital markets via securitization.
** Please spare me the canard that it makes markets more “efficient”. Where is the proof that having markets be more “efficient” than they were in 2002 has done one iota of good in terms of benefits to the real economy? In fact, academics are now increasingly arguing for the need for transaction taxes because trading costs are so low as to make gambling in the financial markets more attractive than real-economy investing. And that is before you get to studies that virtually without exception find HFT to provide junk liquidity: it provides more liquidity when investors don’t need it, when markets are functioning well, and drains it when investors need it most, when conditions are volatile.