Posted by Shyam Moondra
In February, when major commercial banks reached a settlement with the state Attorney Generals and federal regulators concerning mortgage related issues, many analysts thought that the worst was behind and the banks could look forward to a sustained recovery. The bank stocks zoomed up in the expectation that the banks would soon start realizing their normalized earnings. As is often the case, the rally in the bank stocks created a bullish sentiment in the overall market. But then, in May, came a hastily arranged extraordinary conference call with the media in which Jamie Dimon, the CEO of J P Morgan and Chase (JPM), announced that traders in the bank's Chief Investment Office in London had engaged in some complex trades to hedge against possible losses from the bank's bets on credit-default swaps that went awry and that JPM will lose at least $2 billion. However, the loss estimate has now gone up to $5.8 billion and may possibly end up at around $7.5 billion when these trades are completely unwound. This unexpected development unsettled the investors who thought that after the 2008 financial crisis, the banks had implemented procedures to vigilantly guard against taking excessive risks. The JPM revelation crashed the bank stocks as well as the overall market; within days after the conference call, the JPM's market cap declined by more than $35 billion. Before investors could digest this unpleasant surprise from JPM, another shocking news came that the traders at the British bank Barclays had conspired with the traders at other major banks around the world to manipulate the benchmark Libor (London Interbank Offered Rate) interest rate to benefit their respective banks. Barclays was fined a record $453 million and its top three officers resigned. The news provided a strong negative catalyst for the crash in bank stocks as well as the overall market. It's almost as if the cursed financial sector will not let the market breathe easy and these hits keep coming in waves. A cross-continent criminal investigation is still continuing. Some big U.S. banks have reportedly been also implicated in the Barclays scandal. Class-action lawsuits have been filed against the U.S. banks by shareholders and investors who may have lost money because of this illegal interest rate manipulation. Unlike in Europe, the U.S. laws permit punitive damages; therefore, it's impossible to phantom how much money the U.S. banks may eventually have to cough up to settle these charges.
The JPM trading fiasco and the Barclays' criminal manipulation have shaken the faith of investors and some are now beginning to wonder if the culture at major financial institutions has really changed since the go-go years leading up to the 2008 crisis. That crisis caused the collapse of some of the well-known financial institutions and it led to severe economic recession, necessitating the largest bank bailout by the federal government in recent history. Subsequently, the Congress passed the Dodd-Frank Act, which included a new regulatory regime designed to ensure that we will not have a repeat of the 2008 crisis. However, these recent nerve-breaking bank scandals beg the question if banks have really learned anything from the 2008 crisis. Is it really possible to fix the financial sector, given that no law can ever change the human nature and greed?
Why can't banks find a sound and stable footing?
There are four reasons why the financial sector is not showing any signs of stability and orderliness:
· In the aftermath of the 2008 financial crisis, the big banks became even more big. JPM acquired the troubled Wall Street firm Bear Stearns and the banking assets of Washington Mutual. Bank of America acquired Merrill Lynch, MBNA Corp., and Countrywide Financial. Wells Fargo acquired Wachovia. Bigger banks mean more operational complexity and more difficulty in managing them effectively. It's almost impossible for the CEO to know everything that's going on in a big bank and, therefore, it's unrealistic to expect that a single person at the top can possibly guarantee that all the bank policies and procedures would be strictly followed by the greedy investment bankers at all times.
· Since the 2008 crisis, banks have, in general, become more conservative in their primary business of lending to businesses and consumers. In the face of astronomical losses in the mortgage business, the banks became way too cautious in approving new mortgage applications (which is making it harder for the housing sector to recover). So that means big banks have a lot of money lying around doing nothing. Too much money makes people do careless and stupid things, as we saw in the case of JPM's hedging bet. In that sense, the big size itself has become a drawback that is making bankers do unpredictable things, creating a volatile environment.
· During the 2000's, the banks made tons of money in sophisticated "innovative" products such as mortgage-based securities and credit-default swaps. Excessive bank profits led to oversized compensation packages for traders, portfolio managers, and other investment bankers. The more money they made, the more risk seeker they became. The traders suffered from impulsive betting disorder in the mode of gamblers. They would do anything to turn a profit, blurring the line of demarcation between what is ethical and unethical or what is legal and illegal. However, when the housing bubble bursted, the financial crisis ensued which led to the tough Dodd-Frank regulatory bill. Unfortunately, while banks have become somewhat cautious and they have implemented claw-back rules (excessive trading losses mean traders forfeiting past bonuses and other forms of compensation such as stock options) to discourage the traders from taking excessive risks, the culture of greed and excess is proving to be slow to change and that's what led to the JPM and Barlclays incidents. Manipulation and insider trading are rampant on the Wall Street. In general, the banks have lower ethical standards today than they did during the 1990's and prior. One of the reasons why traders would cross the line and engage in unethical or outright illegal activities was that the regulatory bodies were unwilling or unable to catch them. The absence of effective enforcement only encouraged the traders to continue their illegal activities unabated. Some of that attitude is still continuing on the Wall Street even today. The enforcement agencies either lack resources or are unequipped to uncover illegal activities committed by high-tech savvy traders.
· Computer algorithm driven trading in stocks, bonds, options, credit default swaps, and commodities is catching on. Because of the complexity of the assets being traded, even the professional traders don't always know what they are doing, as was evident in the JPM fiasco where traders thought they were hedging their risky bets; but as it turned out, their strategy was flawed and the hedge itself became too risky. High-speed computers have also led to new techniques such as high frequency trading and quote stuffing that are often combined with the extensive use of short selling and options trading to turn a profit. The traders call this strategizing but others say it's manipulation. Most observers believe that the markets today are rigged by big players such as investment banks and hedge funds. These new trends have made the individual retail investors leave the markets altogether, which is evident from the declining trading volume on the public exchanges. It appears that the markets have become a game played by big financial institutions against each other which adds absolutely nothing in terms of capital formation and job creation. The market goes up and then down and then up again, as if it's manipulated to coincide with options expiry dates.
Where do we go from here?
In view of the non-stop bank scandals and market volatility, the question is what can be done to bring stability and transparency to the financial sector which is essential for future economic growth and prosperity. The Dodd-Frank Act is a major step forward, but the recent JPM and Barclays incidents show that more needs to be done. Here are a few suggestions that would help bring more stability and orderliness in the financial markets, which would, hopefully, bring back the retail investors who deserted the markets thinking that they were rigged by big players:
· While there is no easy formula for reducing the size of banks without excessively meddling in the functioning of the private sector, we could increase the capital ratio required beyond what has been proposed in Basel Capital Accord. With stringent capital requirements, the banks will have less "free" money with which to gamble. The government could also force the banks to divest certain non-core businesses to reduce their size.
· Strengthen the role of regulators. Apparently, there were on-site regulators in JPM's London office but somehow they didn't catch the trades that led to massive losses. May be Congress needs to provide more funding for regulatory bodies such as SEC, CFTC, and FDIC, and impose tougher punishment, beyond monetary fines, for violators including mandatory jail terms for the top officers of the institutions engaged in criminal activities.
· In the last ten years or so, trading in all kinds of risky derivatives has become a norm. These trades have brought volatility and unpredictability in the financial markets. Warren Buffett once called these derivatives as equivalent of financial weapons of mass destruction. In fact, trading in derivatives precipitated the collapse of some prominent financial institutions such as Lehman Brothers. The government should consider limiting the amount of trading permitted in derivatives by any single bank or hedge fund.
· To discourage computerized trading, the government could impose a hefty transaction fee for day trades and a much higher income tax rate on profits from day trades (as high as 75%), or impose a minimum holding period (e.g., three business days) for all asset purchases. Quote-stuffing should be banned. We could also put limits on short selling (e.g., no more than 3-5% of outstanding shares) and options trading in any given stock. These limits will take away the tools that big players use to manipulate the markets and cause extreme volatility. The margin requirements, especially for commodity trades, should be increased to discourage highly leveraged trades that lead to disasters when the markets make unexpected big moves, up or down.
The banks provide credit that lubricates the economy. Therefore, it's vitally important that the financial institutions are healthy and are free from frequent scandals that negatively affect the faith in the system. The investors need to have confidence that the financial markets are not being manipulated by big players and are not as volatile as they have been in the last decade or so. While the government needs to do more in the area of enforcement, the banks must also do more to change their corporate culture by strictly enforcing their own procedures to guard against their employees taking excessive risks or engaging in illegal activities.
