UnRisk Omega

The Finance-Government Complex & The End of U.S. Economic Dominance

Banks remain in the ICU (intensive care unit). Even after around $900 billion in new capital, the global banking system remains short of capital by around $1-2 trillion. This translates into an effective reduction in available credit of around 20-30% from previous levels.

Recent excitement about the "stress tests" of U.S. banks misses an essential point. At best if you accept the premises of the test, the risk of failure of these institutions is much reduced. But the banks’ ability to support lending levels that prevailed in say 2007 has not been restored. In short, the "credit crunch" or shortage of borrowing will continue for a prolonged period.

The financial system will need continued government support for some time to come. The performance of governments trying to rehabilitate the financial system has been problematic. Increasingly, government officials have become focused on “reassuring” the public and maintaining “confidence”. The “political spin” has dominated substance. Many government proposals are “stillborn”; for example, progress on the famed Public Private Investment Partnership (“PPIP”) has been painfully slow.

In April 2009, Elizabeth Warren, Chairperson of the TARP Oversight Panel Report questioned the very approach to resolving the problems of the financial system: “Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury’s [PPIP] approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from non-functioning markets for troubled assets. On the other hand, it is possible that Treasury’s approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth.”

Richard Neiman (New York State Superintendent of Banks) and John Sununu (former New Hampshire Senator), two other panel members, issued dissenting findings noting: “We are concerned that the prominence of alternate approaches presented in the report, particularly reorganization through nationalization, could incorrectly imply both that the banking system is insolvent and that the new administration does not have a workable plan.” Many would question the selection of the words “incorrectly imply”.

Constant changes do not suggest a consistent and well thought out strategy in dealing with the problems. Less than rigorous stress tests, using taxpayers monies in different guises provide lopsided subsidies for private investors to buy distressed assets with minimal risk or converting preferred stock into shares to avoid having to seek additional congressional mandates suggest a highly politicised and ideological approach. One online commentator noted the intersection between Wall Street, Constitution Avenue and Main Street was best named: “Confusion Corner”.

Suggestions of political influence and a palpable lack of transparency are emerging. There are allegations that the Henry Paulson, the previous U.S. Treasury Secretary, may have “pushed” Bank of America to consummate its controversial acquisition of Merrill Lynch when it sought to withdraw after additional losses came to light. Certainly, the purchase of Merrill Lynch does not fit comfortably with Ken Lewis’ (Bank of America’s Chairman) earlier statement that “he had just about as much fun in investment banking as he could take”.

The Treasury secretary is alleged to have suggested that Bank of America’s management and board could be removed if it did not proceed. There are also suggestions that both the Treasury and Bank of America decided to avoid public disclosure of these events.

The appointment of Timothy Giethner and Larry Summers initially was viewed favourably. The feeling was that “they knew where the bodies were buried”. Critics pointed out that this was because they may have put them there! The “closeness” between banks and government officials and regulators that is being exposed daily is increasingly part of the problem in dealing with the real issues.

Mancur Olson, the American economist, in his books (The Logic of Collective Action and The Rise and Decline of Nations), speculated that small distributional coalitions tend to form over time in developed nations and influence policies in their favor through intensive, well funded lobbying. The policies result in benefits for the coalitions and its members but large costs borne by the rest of population. Over time, the incentive structure means that more distributional coalitions accumulate burdening and ultimately paralysing the economic system causing inevitable and irretrievable economic decline.

Government attempts to deal with the problems of the financial system, especially in the U.S.A., Great Britain and other countries, may illustrate Olson’s thesis. Active well funded lobbying efforts and “regulatory capture” is impeding necessary actions to make needed changes in the financial system. For example, the Centre of Public Integrity reported that the expenditure on lobbying and political contribution of the top 25 sub-prime mortgage originators, most linked to large U.S. banks, was around $380 million (the Economist (9 May 2009).

Larry Summers, an uncompromising advocate of deregulation and liberalization blamed the Asian crisis, in part, on “crony capitalism”. Increasingly, government actions to rescue and re-regulate the financial system display many of the characteristics of the policies that Summers once criticised.

The phrase - “military industrial complex” - described the complex inter-relationships and influences that shaped America in the post-war era. The “finance government complex” (dubbed “Government Sachs” by its critics) replaced the original arrangement in the late twentieth century and may well prove to be the undoing of American economic dominance.

© 2009 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

Banking Fortunes – From “Catastrophic!” to “Just Awful”!

The recent rally in equity markets – the largest for decades – was predicated, in part, on the improving fortune of banks.

Banks reported better than expected profits. U.S. banks seem likely to pass the “stress” test. Repayment of taxpayers funds by some institutions, at least, seemed imminent. Scrutiny suggests that the episode reflected Adlai Stevenson’s logic: “These are conclusions on which I base my facts.”

Banks beat “well managed” low-ball expectations. In the last quarter of 2008, publicly traded banks lost $52 billion. Despite a return to profitability for some institutions, in the first quarter of 2009, banks are still expected to lose around $34 billion. For example, UBS and Morgan Stanley recorded losses.

The quality of earnings was questionable. Core businesses declined by 20-30%. Trading revenues, especially fixed income, rose sharply at most big banks reflecting high volumes of bond issuance, especially investment grade corporate issues and government guaranteed bank debt.

Corporate issuance was the result of the continued tightening in credit availability as banks reduced balance sheet. The issuance of government guaranteed bank debt provided underwriters with a “double subsidy” – the government guaranteed the debt but then allowed the banks to earn generous fees from underwriting government guaranteed debt.

High volatility generated strong trading revenues. Key factors were increased client flows and increases in bid-offer spreads (by up to 300% in some products). High trading revenues also reflect principal position taking and trading. It will be interesting to see if trading revenues are sustainable.

Questions remain about the impact of payments by AIG to major banks. Conspiracy theories notwithstanding, it seems likely that these were collateral amounts due to the counterparty or settlement of positions that were terminated. At a minimum, the banks benefited from a one-off increase in trading volume and also larger than normal bid-offer spreads on these closeouts reflecting the distressed condition of AIG.

The banks also benefited from revaluing their own debt where credit spread widened. The theory is that the bank could currently purchase the debt at a value lower than face values and retire them to recognise the gain. Unfortunately, banks are not in position to realise this “paper” gain and ultimately if the debt is repaid at maturity then the “gain” disappears. If you are confused then revaluation of issued debt worked differently at Morgan Stanley. The bank would have been profitable without a $1.5bn accounting charge caused by an increase in the price of its debt from lower credit spreads.

Earning were also helped by a series of one-off factors. Bank of America realised a large gain on the sale of its stake in China Construction Bank and also revalued some acquired assets as part of the closing of its Merrill Lynch acquisition.

Goldman Sach’s changed it balance date reporting results to the end of March rather than February. Given that its last financials were for the year to the end of November 2008, Goldmans separately reported a loss for December 2008. It is not clear how much Goldmans Sachs profit benefited from the change in the reporting dates.

Barclays Bank recently sold its iShares unit (a profitable unit which contributed around 50% of the earnings of BGI (Barclays Global Investors) to a private equity firm for $4.2 billion allowing the bank to book a gain of $2.2 billion that boosted capital ratios. CVC Capital only paid $1.05 billion with the rest ($3.1 billion) being borrowed from Barclays itself. The loan was for 5 years and Barclays is required to keep the majority of the debt on balance sheet for at least five years.

In effect, the gain and capital increase is lower than the cash received (in effect, Barclays is treating part of its loan as profit and capital!). In addition, senior executives of Barclays received substantial gains from the sale under a compensation scheme where BGI employees received shares and options over (up to) 10.3 % of the division’s equity.

Effects of changes in mark-to-market accounting standards, which arguably reflected political and industry pressure, are also not clear. New guidance permits banks to exclude losses deemed “temporary” and also allows significant subjectivity in valuing positions. This may improve the financial position and overstate both earnings and capital. Some commentators believe that the changes could increase earnings by up to 10 to 15% and capital by up to 20%.

The market ignored continuing increases in bad debts and provisions. After all “that’s so yesterday!” Further losses are likely in consumer lending (e.g. mortgages, credit cards and auto loans), corporate and commercial lending.

In recent years, it has become an article of accepted faith that corporate debt levels have fallen. In aggregate, that is perfectly true. However, the debt has become concentrated in a number of sectors - commercial property, merger financing, private equity/ leveraged finance and infrastructure and resource financing.

The overall quality of debt has deteriorated significantly. In 2008, over 70% of all rated debt were non-investment grade (“junk”). This is an increase from less than 30% in 1980 and around 50% in 1990. The debt is also heavily reliant on collateral; the loans are secured against financial assets (shares and property). Reduced ability to service the debt and falling collateral values may prove problematic. For example, the recent distressed sale of the John Hancock Tower produced around 50% of the value paid a few years earlier.

In April 2009, the International Monetary Fund (“IMF”) estimated that banks and other financial institutions face aggregate losses of $4.1 trillion, an increase from $2.2 trillion in January 2009 and $1.4 trillion in October 2009. Around $2.7 trillion of the losses are expected to be borne by banks. The IMF estimated that in the United States banks had reported $510 billion in write-downs to date and face additional write downs of $550 billion. Euro zone banks had reported $154 billion in write-downs face a further $750 billion in losses. British banks had written down $110 billion and face an additional $200 billion in write offs.

Banks may not be properly provisioned for these further write-downs. Recent accounting standards made it difficult for banks to dynamically provision whereby banks provided in low loss years for any eventual increase in loans losses when the economic cycle turns. Criticisms regarding income smoothing led to this practice being discontinued. Increasing bad debt will flow directly into bank earnings as credit losses increase as the real economy slows.

The stress tests do not provide comfort regarding the health of the banks. As Nouriel Roubini, Chairperson of RGE Monitor, has pointed out the likely macro-economic environment is likely to be significantly worse than the adverse scenarios used. The Federal Reserve hinted that banks even banks that passed the “stress test” would be required to hold extra capital. This is puzzling as surely a bank is appropriately capitalised or it is not. Given that the test is the basis for setting solvency capital requirements, this is hardly reassuring or a guarantee that further taxpayer funded recapitilisation of the banking system is not going to be needed.

The proposal floated by some banks to return taxpayer capital misses an essential point. The banks did not offer to waive the government/ FDIC guarantees, which have allowed them to fund in the capital markets. The suspicion is that the proposal had more to do with avoiding close public scrutiny of compensation and hiring practices. Goldman’s compensation costs increased 18% in the first Quarter while employee numbers were down around 7% translating into a 27% increase in employee costs.

The reality is that the global economic system is de-leveraging and levels of debt must be reduced. As result, asset values are declining and sustainable growth levels have fallen significantly. In this environment, banks are likely to continue to suffer losses on assets (bad debts and further write offs) and earnings will remain sluggish (lower loan demand and lower levels of financial transactions). Higher funding costs and the need to raise capital compound the difficulties. For the banks currently: “On the liability side, some things aren’t right and on the asset side, nothing’s left.”

Many major global bank shares are still, on average, trading at levels 70%-90% below their highs. Following the collapse of the “bubble” economy, Japanese banks staged a number of significant recoveries in share price before falling sharply necessitating government intervention to recapitalise and consolidate the banking system.

There seems to be a patent unwillingness to admit to and confront the problems facing the industry. Recognition of the problem is generally a prerequisite to working towards a solution.

Amusingly, Peter Hahn, a former managing director of CitiGroup and now a fellow at London’s Cass Business School was reported by Bloomberg as saying: “When you look at the income numbers that have been put out by banks recently they contain so much fudge and financial manipulation. You could say that the automobile industry has a clearer future at the moment.”

Banks have gone from catastrophic to just awful. By most standards, that condition does not constitute a necessary and sufficient condition for a recovery in the global economy.

© 2009 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

Banks – The “V”, “U” or “L” Recovery

In 2007, equity markets fell out of love with financial institutions, especially those with large investment banking operations. 2008 saw something of reconciliation - the bigger the write-off, the bigger the dividend cut, the bigger the capital raising, perversely the greater the investor buying interest. By the end of 2008, there seems to have been an irreconciliable breakdown in relationships that no counsellor could fix.

The outlook for banks remains grim.

The asset quality of major banks remains uncertain. Svein Andresen, secretary general of the Financial Stability Forum, which is made up of global regulators and central bankers, recently told a conference of bankers in Cannes: “We are now 10 months through this crisis and some of the major banks have yet to make disclosure in [crucial] areas.”

Despite significant writedowns, sub-prime assets remain vulnerable. Other assets - consumer credit, SME loans, corporate lending and high yield leverage loans to private equity transactions- all look vulnerable as the real economy slows. Banks have increased provisions but it is not clear whether they will be adequate.

Bank balance sheets have changed significantly. Traditional commercial bank assets consisted primarily of loans and high quality securities. Traditional investment bank assets consisted of government securities and the inventory of trading securities.

In recent years, asset credit quality has deteriorated. High quality borrowers have dis-intermediated the banks financing directly from investors. Banks also hold lower quality assets to boost returns.

Bank balance sheets also now hold investments – private equity stakes, principal investments, hedge fund equity, different slices of risk in structured finance transaction and derivatives (of varying degrees of complexity). Sometimes, the assets don’t appear on balance sheet being held in complex off-balance sheet structures with various components of risk being retained by the bank. Further write-downs in asset values cannot be discounted.

Banks require re-capitalisation. The capital is requiredto cover losses. Capital is also needed for assets returning onto their balance sheet (as the vehicles of the “shadow banking system” are unwound). This capital is required to restore bank balance sheets. Additional capital will be needed to support future growth. Availability of capital, high cost of new capital and dilution of earnings will impinge upon future performance.

Earning growth in recent years has been driven by a rapid expansion of lending – both traditional and disguised forms such as securitisation and derivatives activity. Bank balance sheets have expanded at rates well above GDP expansion. Lower volumes in the future will mean lower earnings.

Lack of lending capacity may also affect other activities. Corporate finance and advisory fees are driven by the capacity to finance transactions and also co-investing in risk positions. Lower origination of lending driven deals may reduce this income significantly. Banking fees for leveraged finance deals are down 90%.

Structured finance has contributed strongly to earnings in recent years. Securitisation, including CDO activity, has been a major growth area. Volumes have collapsed. The slowdown in structured finance has complex effects. Banks generated large earnings from off balance sheet vehicles in the shadow banking system. The vehicles provided banks with the ability to “park” assets and reduce capital. They also provided significant revenue – management fees; debt issuance fees and trading revenues. Recovery in these earnings is unlikely any time soon.

Trading revenue has been a bright spot. Increased volatility and much wider bid-offer spread have generated increases in both client driven and proprietary trading earnings. Volatility and the need to adjust trading positions created strong trading flows and earnings. As the markets stabilise, trading flows and earnings decline.

Several factors may limit trading income. Derivatives and structured investments, especially complex products, generated significant earnings. Problems in structured finance highlighted concerns about complexity, transparency and valuation. Market volatility has resulted in significant losses in some structured investments. Revenues may diminish as investors and borrowers curtail their use of such instruments preferring simpler products that are less profitable to the bank.

Trading revenues relied heavily on hedge funds and financial sponsors. Hedge fund activity is likely to slow through consolidation, investor redemptions and reduced leverage. Derivatives and hedging activity from private equity transactions and structured finance has been significant. Hedging revenues typically contribute 50% or more of bank earnings from a private equity transaction. Reduction in financial sponsor activity will limit revenue from this source.

Banks have increasingly relied on proprietary trading to supplement earnings. This increases risk and depends on the availability of capital. It relies on availability of counterparties and liquidity. Concern about counterparty risk and reduction in market liquidity in some products increases the risk of this activity and reduces its earning potential.

Future earnings will be affected by the availability of risk capital. The banks may not be able to access capital to the extent needed. The demise of the shadow banking system will mean that purchased capital will not be available. Regulators may also increase capital levels for some transactions exacerbating the capital problem.

Risk models in banks are a function of market volatility. The low volatility regime of recent years reduced the amount of capital needed. Increased market volatility will increase the amount of capital needed. This may restrict the level of risk taking and therefore earnings potential.

Higher costs will also increase limiting earning recovery. Bank funding costs have increased. Most firms have been forced to issue substantial amounts of term debt to fund assets returning to balance sheet and protect against liquidity risk. To the extent, that these costs cannot be passed through to borrowers, the higher funding costs will affect future funding.

Banks have issued high cost equity to re-capitalise their balance sheets. Hybrid capital issues paying between 7.00% and 14.00 % pa will be drag on future earnings. Highly dilutionary equity issues (often at a discount to a share price that had fallen significantly) will impede earnings per share growth and return on capital.

Banks also face additional short-term costs. Litigation against banks has increased. There may also be prosecutions of banks. The costs of these are unknown. In the longer term, banks face higher regulatory and compliance costs.

Accounting factors may also affect any earnings recovery. FAS157 allows the entity's own credit risk to be used in establishing the value of its liabilities. Changes in the entity's credit standing are therefore reflected as changes in fair value. This results in gains for credit downgrades and losses for credit upgrades.

As credit spreads increased, banks have taken substantial profits to earnings from revaluing their own liabilities. If markets stabilise and the credit spreads for banks improves then banks will have to reverse these gains. There may be significant mark-to-market losses especially on new debt issues by banks at high credit spreads since mid-2007. Investors are looking for a rapid recovery in bank earnings. Earnings may recover but the “gilded age” of bank profits may be difficult to recapture.

Glamorous banks reliant on “voodoo banking” may find it difficult to achieve the high performance of the “go-go” years.

Banks with sound traditional franchises that have avoided the worst excesses of the last 10-15 years will do well in the changed market environment. Such old fashioned banking may ironically do well in the “new” environment. Interest rates that they charge customers have increased. Bank deposits have become far more attractive than other investments. Stronger banks have also benefited from a “flight to quality”.

Will the recovery in bank stocks take the form of “V” or “U”? It may be a “L”. With the Northern Rock and Bear Stearns bailouts, central banks and governments have signaled that major banks are “too big to fail”. This is a necessary but not sufficient condition for recovery of bank earnings and stock prices. The recovery might take the form of a “L” (Kirsten ITC font) – note the small upturn at the far right of the flat bottom.

© 2008 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.

Banking on Steriods

Earlier in 2008, CitiGroup announced that it was seeking Board members who had “expertise in finance and investments”. What was the experience and expertise of the Citi Board and senior management that has registered over US$50 billion in losses? Shareholders and taxpayers, that have provided over billions in new capital, will be hoping that the new recruits also possess “magic” to restore Citi’s fortunes. The same applies to the banking sector generally.

Until the late 1970s/ early 1980s, banking was highly regulated. It was the world of George Bailey (played by Jimmy Stewart) in It’s A Wonderful Life. Community banking was the rule. The banker could dip into his “honeymoon money” to stave of a potential bank run. It also fueled jokes - the “3-6-3” rule; borrow at 3%; lend at 6%; hit the golf course at 3 p.m.

Once de-regulated, banks evolved into complex organisations providing varied financial services. De-regulation brought benefits for the economy (better access to capital and more varied investment opportunities) and the banks (growth and higher profits).

Over the last 15 years, increased competition (within the industry and increasingly from non-banking institutions) and the reduction of earning from the commoditisation of products forced banks to rely on “voodoo banking” - performance enhancement to boost returns.

Traditionally banks made loans that tied up their capital for long periods e.g. up to 25/30 years in a mortgage. In the new “originate to distribute” model, banks “underwrote” the loan, “warehoused” it on balance sheet for a short time and then parceled them up with other loans and created securities that could be sold to investors (“securitisation”). The bank tied up capital for a short time (until the loans were sold off) and then the same capital could be reused and the process repeated. Interest earnings over the life of the loan could be discounted back and recognised immediately. Banks increased the “velocity of capital” – effectively sweating the same capital harder to increase returns.

In the traditional model, banks earned the net interest rate margin over the life of the loan – “annuity” income. When loan assets are sold off and the earnings recognised up-front, banks need to make new loans to be sold off to maintain earnings. This created pressure on banks to find “new” borrowers. Initially, creditworthy borrowers without access to credit in the regulated banking environment entered the market. Over time, banks were forced to “innovate” to maintain lending volumes.

Banks created substantial new markets for borrowing: ? Retail clients – expanding traditional lending (housing and car finance) and developing new credit facilities (credit cards and home equity loans). ? Private equity – providing borrowings in leveraged buyouts and sundry other highly leveraged transactions. ? Hedge funds/ private investors – providing (often) high levels of debt against the value of assets.

Banks increasingly also out sourced the origination of the loans to brokers, incentivised by large “upfront” fees.

The expansion in debt provision relied increasingly on quantitative models for assessing risk. It also relied on collateral - the borrower put up a portion of the price of the asset and agreed to cover any fall in value with additional cash cover.

The model allowed banks to expand the quantum of loans and allowed extension of credit to lower rated borrowers. Banks did not plan to hold the loan long term and were only exposed to “underwriting” risk in the period before the loans were sold off. Where the loan was collateralised, the value of the asset and the agreement to “top up” the collateral where the asset value fell was considered to provide ample protection.

Favorable regulatory rules (the capital required was modest), optimistic views of market liquidity and faith in models underpinned this growth in lending.

Banks also increased their trading activities, especially in derivatives and other financial products. Initially, this was targeted at companies and investors seeking to manage financial risk. Over time it increasingly focused on creating risk allowing investors to increase returns and companies to lower borrowing costs or improve currency rates. As profits margins eroded, banks created ever more complex exotic products, usually incorporating derivatives. Derivatives also increasingly became a way to provide additional leverage to customers.

The development of hedge funds was especially important. They borrowed money (against securities offered as collateral) and were extensive users of derivatives. They also traded frequently and aggressively boosting volumes. Prime broking services (bundling settlement, clearing, financial and capital raising) emerged as a major source of earnings for some banks.

Banks also increased their own risk taking. Traditionally, banks took little or no risk other than credit risk. Over time, banks increasingly assumed market risk and investment risk. Originally, banks traded financial products primarily as “agents” standing between two closely matched counterparties. Over time banks became principals in order to provide clients with better, more immediate execution and also increase profit margins.

Increased risk taking was also dictated by business contingencies. Advisory mandates (mergers and acquisition; corporate finance work) were conditional on extension of credit. Banks increasingly “seeded” or invested in hedge funds to gain preferential access to business.

Clients often sought “alignment” of interests requiring banks to take risk positions in transactions. This evolved into the “principal” business as banks increasingly made high risk investment in transactions. In some banks, this evolved into a model where the bank acted purely as “principal” rolling back the clock to the days of J.P. Morgan. Banks convinced themselves of the strategy on the basis that the risks were acceptable (it was their deal after all!), the risk could be always sold off at a price (market were liquid) and (the real reason) high returns.

Enhanced revenues (growing volumes and increasing risk) were augmented by increased leverage and adroit capital management. “Regulatory arbitrage” evolved into a business model. Required risk capital was reduced by creating the “shadow” banking system – a complex network of off balance sheet vehicle and hedge funds. Risk was transferred into the “unregulated” shadow banking system. The strategies exploited bank capital rules. Some or all of the real risk remained indirectly with the originating bank.

Banks reduced “real” equity – common shares – by substituting creative hybrid capital instruments that reduced the cost of capital. The structures generally used high income to attract investors, especially retail investors, while disguising the (less obvious) equity price risk. In some cases, banks used these new forms of capital to repurchase shares to boost returns. For example, CitiGroup repurchased US$12.8 billion of its shares in 2005 and an additional US$7 billion in 2006.

Banks increasingly “hollowed out” capital and liquidity reserves – that is, they reduced these to minimum levels. Concepts of “purchased” capital and “purchased” liquidity gained in popularity. The theory was that banks did not need to hold equity and cash buffers as these items could always be purchased in the market at a price.

Bank profits in recent history were driven by rapid and large growth in lending, trading revenues and increased risk taking. Banking returns were underwritten by an extremely favourable economic environment (a long period of relatively uninterrupted expansion, low inflation, low interest rates and the “dividends” from the end of communism and growth in international trade)

Bankers would argue that the source of higher returns was “innovation”. John Kenneth Galbraith, in A Short History of Financial Euphoria, noted that: “ Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.”

Elite athletes often use performance enhancement drugs to boost performance. Voodoo banking operated similarly enabling banks to enhance short-term performance whilst risking longer-term damage.

© 2008 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

“Business Models”/ “Corporate Intelligence”

It’s that time of year. The current year is almost done – money has been made or lost. Time to move on. Plans are made for the year ahead. Management in investment banks step forward to make “plans”. They lay down strategy to lead the vast retinue of traders, salespeople and support staff into battle. The leadership’s contribution is strictly “business models”.

Groucho Marx noted with great prescience: “military intelligence is a contradiction in terms”. “Bank management” or “banking strategy” lives up to the proposition.

A casual observer will find it difficult just to work out who actually runs the place. American investment banks have numerous Managing Directors. One banker created the following rankings: MD/ NR (Managing Director/ Not Really); MD/NVI (Managing Director/ Non Very Important); MD/ PLN (Managing Director/ Please Leave Now). There are co-heads and joint-heads. There are more Chairmen and Vice Chairman than any reasonable organisation could require. Asking anyone adds to the confusion. The person asked always insists that he or she is in charge, at least until you ask the next person. An organisation chart, if it exists, will have the complexity of the wiring diagram for a nuclear warhead.

In reality, banks are the last feudal kingdoms. Their rulers are omnipotent, divine shogun warlords. Their key lieutenants are Ronin (wandering mercenary samurai) who roam financial markets ready to ally themselves to any warlord for a share of plunder.

Trading rooms are collections of fiefdoms. Each ruler has absolute authority over his or her subjects. Power lies in the tight knit band of knights that are allied to him or her. They are united only in their hatred of the common enemy, other people with their firm who would dare infringe on their territory. Competitors are minor irritants. The real enemy is within.

Fealty is based on the rewards that the ruler parcels out to subordinates – the share of plunder. Compromising photos of the individual are helpful. One with someone of the same or opposite sex other than their partner are valued. Photos with an animal performing some sexual act are highly sought after. Knowledge of past financial indiscretions or cover ups are useful. Occasional bloodletting is unavoidable. This takes the form of the random brutal execution of a formerly trusted associate for no plausible reason. It has no purpose other than to engender fear in the remaining followers. The major court game is “divide and conquer” with the ruler playing his people off against each other. It all ends in a palace coup d’etat. Then, the cycle just repeats itself.

The shortcomings of the top managers in banks and dealers make them vulnerable to the modern version of snake oil salesmen – management consultants. Major consulting firms play on the barely concealed insecurity of the numerous Chairmen and Vice-Chairmen of banks and dealers. After all, there are so many to choose from. The impenetrable jargon of management speak confuses and dazzles them. They come to rely on a retinue of retained consultants to run the place. Consultants provide a buffer against the feuding warlords. They provide excuses for hard decisions. The consultants also provide a convenient scapegoat when things go awry.

Management of most firms is a succession of fads. Our glorious leaders lurch from one to the next, pissing away enormous sums of money in the process. The fads are a curious mixture of homely common sense packaged as high science and incomprehensible Orwellian newspeak. Here are some of the fads that I along with my long suffering colleagues have endured:

"Diversification"- Let’s do several things that we don’t know anything about badly.

"Sticking-to-the knitting" - Let’s get back to doing what we once did if anybody can remember what it is and how to do it.

"Decentralisation" - Massive duplication, confusion and creation of thousands of petty empires.

"Matrix structures" - Everybody reports to everybody, no one knows whom they work for and there is no accountability.

"Flat organisations" -Managers who can’t manage now manage several hundred direct reports.

"Business process re-organisation" - A process by which you cut everything that is essential leaving only everything that you don’t need.

Befuddling buzzwords permeate all conversation: transformation, best-of-breed, competitive advantage, paradigm, silos, concept, reinvention, template, benchmark, insourcing, outsourcing, off-line, online, CRM, KPI, TQM, B2B; B2C etc. We go from “hugging the leader within” to “hardball” where we “unleash massive and overwhelming force” against competitors, mostly within the firm and sometimes outside. Only two terms actually mean anything. Downsizing is code for mass sackings. Multi-skilling is code for doubling each employee’s workload. It is applied liberally to the back-office.

The quality of bank management is evident in a recent attempt by the Commonwealth Bank of Australia, my old alma mater, to sharpen up its image (see “Dressing Up Down Under” Euromoney (January 2006) at 7). It took the form of a “grooming handbook”. The recommendation included advice on jewelery – a maximum of two rings on each hand and earrings the size of a 10 cent piece. Flesh coloured smooth finish T shirts bras were recommended. Shiny finish stockings were to be avoided – they made legs look larger. It was not exactly clear whether the recommendations were targeted at male or female staff. There was some male specific advice. Men should buy 6 to 10 pairs of “matching” socks. “Specialist foot powders were recommended for those with smelly feet. Older males were advised specifically to trim nose hair as “hair in those areas can increase as you age”. The guidelines had been developed by a specialist consultancy called “Corporate Intelligence”.

© Satyajit Das 2006; All rights reserved.

The above is adapted from Traders Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das (2006, FT - Prentice Hall, London, ISBN 0273 70474 5) available at all good book stores or online at www.pearson-ed.com.

Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/ Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider's account of derivatives trading and the financial products business filled with black humour and satire. The book has been described by the Financial Times, London as " fascinating reading … explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry". He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.