The false prosperity of the banks

The last five years have certainly been... eventful when it comes to the world of high finance. In 2008, the world discovered that the geniuses to whom the public had entrusted trillions of dollars didn't really have a clue how to manage it responsibly.  There is plenty of blame to go around: people borrowed money that they couldn't afford to pay back, because the banks were offering absurdly low interest rates and astonishingly easy terms, because the Federal Reserve wanted to spur economic growth through artificial and easy credit, because the people of the West just couldn't get enough of cheap stuff. The cycle goes on and on, but it should be made very clear that much of the blame does reside with the banks and the products that they sold the rest of us.

You would think, then, that after five years of bailouts and record profits, the banks are doing quite well.

You would be quite wrong.

In the interests of transparency, I will go so far as to admit that I work for a very large international investment bank right now. I will also admit that my previous job was for another, similar bank.

Now, I'm not actually a bankster myself- a lot of people have this complete misconception of how banks actually operate, they think that everyone is either a banker or a trader, without understanding that the banking and trading units are actually pretty small cogs in the vast machines that are banks.

Being eyeballs-deep in the infrastructure side of banking provides a bit of a different perspective to those who (rightly) bash the banking industry for being a massive scam.

The reality of banking is that the industry is in severe crisis, has been for years, and shows no sign of getting out of it, now or ever again.

According to a recent analyst poll taken by the WSJ in the wake of some horribly embarrassing revelations about a certain bank's infrastructure problems, banking stocks currently trade at a roughly 30% discount to the rest of the market. And if you're working in the industry, it's not that hard to see why.

Despite the fact that banks currently have record amounts of capital on their books, they are facing possibly the most difficult and expensive environment in their history- and I can tell you from sometimes painful personal experience that not one penny of that extra capital is coming down to employees at ground level. Even the traders and bankers who generate the profits aren't doing all that well- many senior MDs are looking to leave to other industries because they're so sick of seeing their bonuses being subjected to draconian claw-back provisions.

The loss of talent within the sector is considerable. Fresh graduates are no longer looking at banking as their number one career choice (good thing too); they're now looking at tech companies like Google and Facebook, and various startups like Relationship Science- sort of like a Facebook on steroids for executives- instead. We're losing talent to other industries, and because of the draconian cost-cutting measures in place at almost every bank, it's becoming next to impossible to replace them. I personally have seen situations where we found good candidates for certain roles, but they turned down the offers because, well, we couldn't afford to pay them well enough.

All major expenditures are going towards regulatory initiatives, instead of building out new businesses. The regulations that were imposed by various regulatory agencies in the wake of the last phase of the current crisis have made business extremely expensive and very unprofitable in general. The prohibitions against proprietary trading are both stringent and very vague- indeed, the combination of the poorly defined "Volcker Rule" and the legislative Frankenstein that is Dodd-Frank have come together to make OTC derivatives trading in the US prohibitively costly.

Dodd-Frank, in particular, has been a truly ridiculous burden on the industry. The bill is some 2,000 pages long and yet still manages to be almost completely incomprehensible. It's a bonanza for accountants and lawyers, because they will be able to charge huge amounts of money to the banks for years to come in order to explain to the banks how all of this garbage works.

For banks themselves, Dodd-Frank's peculiar lack of transparency- in a bill aimed at restoring transparency in the market- has resulted in very costly and quite radical measures being taken to avoid its most absurd requirements.

Case in point: Dodd-Frank reporting requirements demand that every OTC trade that is "reportable" has to be registered in a reporting system within 15 minutes of execution. Furthermore, all OTC trades should, to the greatest extent possible, go through electronic trading systems like MarkitWire, rather than "voice" systems like Bloomberg or Reuters. And every trade that is eligible for "clearing"- a complicated idea that ultimately comes down to netting all of the various counterparty credit exposures through a central hub- has to be cleared with a registered clearing house.

The net result of all of this craziness is that non-US clients- a big part of any international bank's client portfolio- want nothing whatsoever to do with these regulations. So in order to avoid gutting their businesses, banks are switching their internal workings around so that, in accounting terms, their trades go through international entities rather than US ones.

Of course, this also means that the US loses out on a considerable chunk of tax revenue, because if a trade goes through a European entity rather than a US entity, it gets taxed according to European law, not American law.

Net result: American lawmakers passed a bill that harms American interests, and yet is so poorly written and so badly thought-out that the average American wouldn't have a snowflake's chance in hell of understanding it. Well done, Congress!

I should also mention that the Fed has been given expansive powers to regulate the industry, and has chosen to do so by beating up the banks on their P&L attribution processes. This means that the Fed wants to see, from every single business line of every single bank, a comprehensive breakdown of how they made their money every single day- X from rates movements, Y from credit spreads, Z from various volatility components, that sort of thing. The Fed demands that this is made possible for every business- including the securitised trading businesses that deal in highly structured products like collateralised and asset-backed securities.

The problem with all of this is that every bank has to figure out how to calculate all of these attributions, store them somewhere, and then pump the data for every single position down to the Fed.

The USD Swaps Desk at my bank alone has nearly half a million trades on the books. And we're actually not that big compared to some of the other players in the market. Just how in the name of all that is holy does the Fed expect to capture, process, and analyse all of that data?

Answer: it can't. No institution on Earth can. You could hook up as many supercomputers as you want to crunch all of those numbers, and you still wouldn't be able to use all of that data to figure out true systemic risks in the industry. You'd get a gargantuan amount of noise and no signal whatsoever- mostly because, as always, the Fed has no motivation or desire to see that the true systemic risk is not any one bank, but the Federal Reserve system itself.

It's not like the Europeans are any better, by the way. The next major regulatory change coming to the industry will be the implementation of Basel III- a set of regulatory standards that, among other things, requires banks to measure how costly a trade will be in terms of regulatory capital set aside against that trade. These regulations are supported and promoted by various European regulators, such as the UK's FinRA and Germany's BaFin.

The requirements of Basel III are so stringent and so difficult that if my previous employer had to meet them in 2010, it would immediately have gone out of business.

Even in 2014, after more than four years to prepare, most banks aren't ready for Basel III- and most of them can't afford it, but they have to anyway.

Some would argue that all of these regulations are a Good Thing if they make the system safer. Problem is, they don't.

Take the requirements about central clearing. This sounds like a great way to reduce overall systemic risk, because you avoid double-counting the credit risk between all of the various counterparties involved in a trade. Consider: if I have a 300M swap against you, and you have another 200M trade against me, without clearing we would individually measure our risks of the other defaulting and set aside capital against each side of our respective trades- let's say, 10% of each trade, which means that I would hold 30M in reserve and you would hold 20M. With clearing, we would simply net off our exposures, for a total of 100M, and hold capital against that. Both of us would then need to hold only 10M in reserve, thereby freeing up capital to use in other pursuits.

Sounds great, right? And it is- except for one rather thorny problem which the regulators in their infinite wisdom completely overlooked.

You see, clearing houses, like LCH.Clearnet, are funded by fees charged to their members. If ten banks all agree to participate in a clearing house, all ten pay a (not exactly small) fee to that clearing house for the privilege. Now, if one of those banks goes under, the exposure to all of the other banks is limited- but now the clearing house itself is at risk.

Instead of spreading out systemic risk, the new regulations have concentrated it. The system has been made more fragile, not less.

Regulators would counter this by arguing that no clearing house or exchange has ever gone bankrupt in the more than 500-year history of such institutions. To which I respond: by standard models the Crisis of 2008 could never have happened either.

Indeed, the costs of doing business are now so high that most European banks are abandoning the universal banking models that became so popular in the last twenty years.

Barclays is winding down its US investment banking arm and has separated its trading operations into "Core" and "Legacy" books- and amusingly, everyone on the "Core" side wants to go to the "Legacy" side because they get paid well to transfer over, and they get paid well again to unwind the "structured" and "exotic" positions that supposedly got Barclays (really, Lehman) in the first place.

UBS has essentially abandoned its trading and investment banking operations and has returned back to its wealth management and private banking roots.

Credit Suisse has done much the same, shuttering its mainline trading businesses and retrenching heavily throughout the US.

BNP Paribas is still dealing with the fallout of its acquisitions of Fortis and ABN Amro, and various legal wranglings that have pestered it throughout the last several years.

We are now in the very odd situation where American and European regulators are making it impossible for banks to do business- and yet have back-stopped and guaranteed the existence of those institutions through the implementation of rules concerning "Systemically Important Financial Institutions". There are several different types of SIFIs- Global, National, and Regional- and if a given bank is considered a SIFI, well, it pretty much has an implied "too-big-to-fail" tag.

The end result of all of this is that when the next crisis comes- and believe me, it is coming- regulators will face a demon of their own design. The banking sector is now in a mutually abusive relationship with the rest of society: whenever a bank mis-steps, it is fined and regulated and tied down so that it loses money no matter what it does, yet at the same time, society needs these institutions to exist in order to lubricate the engines of the massively inflated credit-based system that the world has become addicted to for the past century.

By the way, I don't want you to come away with the impression that the banks deserve much sympathy. They don't. They messed up horribly and are now reverting back to the levels that they probably should have been at in the first place. It's just that the process of retrenching back to that point is extremely painful and extremely costly- we're talking about unwinding truly gargantuan misallocations of resources, and that sort of thing always requires a significant amount of human pain to accomplish.

Bottom line: we are in very deep trouble, and most of us simply don't know it yet- we're just running around trying to plug the leaks in the dike wall, all the while ignoring the gigantic tsunami wave barreling straight toward us.


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