If banks want to gamble they shouldn’t use your money

Once we got past the pot-kettle irony of Congress lecturing a big bank’s top executives on bad management, the recent hearings on banking regulation provided some valuable insights into the problem and the solution. Most of these were centered on how derivatives trading was not managed very well, and how risk assessment was mostly ignored.

The highlights of the hearings were also the lowlights. Executives from JPMorgan Chase were brought before the Senate Permanent Subcommittee on Investigations to explain how their bank managed to lose over $6 billion last year trading derivatives in London. The largely unspoken agenda of the hearings was a re-examination of the “too big to fail” issue and whether existing regulations, including the Dodd-Frank reforms of 2010, were enough to make those banks behave.

In between the scolding and sound bites there were bits of useful information from the banking executives such as Douglas Braunstein, who had been JPMorgan Chase’s chief rinancial officer last year. As the interrogation became more accusatory, though, the faint but unmistakable scent of potential prosecution wafted in, and the executives’ testimony became increasingly lawyerly and devoid of meaningful content.

The hearings themselves were buttressed by an unusually valuable piece of staff work, a 300-page report, “JPMorgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses.” It paints a very useful picture of the derivatives market and how that bank failed to manage its trading operations.

Despite the hearings, Congress will probably either postpone any significant change, or base any forthcoming action on head counts of those supporting one view or another.

There is no shortage of divergent views on the banking issue. There are those who believe that the Dodd-Frank banking regulations are perfectly adequate but are not being complied with or enforced properly. There are those who believe we made a mistake in dumping the Glass-Steagall separation of commercial and investment banking back in 1999 and should restore it. And there are those who believe that the solution is to break up the too-big-to-fail banks into smaller, life-size organizations.

There is a fourth view which takes a different perspective on the issue, based on the structure of the derivatives market, the management of banking organizations, and the reality of the regulatory environment.

Both regulators and participants have to realize that the contract-based structure of the derivatives market creates what is very close to a zero-sum game. In order for one participant to win, another participant has to lose the same amount. In that respect it resembles gambling more closely than banking.

This structure explains a lot about how derivatives trading operations are managed and how that affects bank organization. Accounting and reporting systems for derivatives trading operations are not really compatible with banks’ traditional balance sheets and income statements and trying to jam them into those models is futile. Evaluating risk presents equally daunting reporting problems for bank management

Perhaps more importantly, though, success in big-money trading involves making decisions that are smarter, or at least less dumb, than the other market players,’ as well as a considerable amount of luck in “guessing right.” Some individuals seem better at this than others and their success encourages a reputation for having the indefinable, near-magical star quality that markets love. They begin to be worshipped in their own organizations and in the markets themselves.

When we look at bank management, we see the kind of winner idolatry and accounting system that is typical of Hollywood. In the movie business, success is ultimately based on magic, since no one can guarantee they can create a successful movie. You can do everything right with cast, story and director… and still produce a flop. Those who succeed more often than others are seen as possessing magical powers, worshipped as stars, and paid fabulous sums to shine. Investing in movies is a gamble.

If the Hollywood movie business is characterized by idolatry, a belief in magical powers, winner-take-all paychecks, dubious management and questionable accounting, how are today’s big banks all that different?

They are different only because in addition to all their big wins and losses in trading, subsidized in part by inexpensive capital supplied by the Federal Reserve, banks still have time to conduct some traditional banking functions. They make loans, take deposits, support commerce, encourage thrift and play an important role in our economic development.

Congress should require that derivatives trading be spun off as separate corporate entities, capitalized in the open market. If these operations are as wonderful as the banks seem to believe, they should have no trouble finding investors. Casinos are filled with people who donate their money in the belief that they are smarter, and luckier, than the other players at the table.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Herald Business Journal.