Easy to call bankers crooks, but are they the only ones?
It’s all too easy to vilify bankers these days. Since the 2008 financial crisis the banking industry has been suffering from a prolonged pandemic of moral self-flagellation promoted by popular culture. Bankers are portrayed in film and television as leeches between crooked politicians and suicidal terrorists.
Saying the Oscar winning Big Short accurately portrays the reality of the zero-sum game, the immutable win-lose law of the markets obscures the true causes of the subprime crisis.
Market making and proprietary trading is creating a market or taking a position in securities that are not listed on an exchange (known as OTC trading). The two activities are interrelated. They require betting, hedging and leveraging the institution’s balance sheet to generate liquidity. It can result in big profits or as we witnessed during the crisis, catastrophic losses that can bring down entire economies.
The author of The Big Short, Michael Lewis, described the beginnings of proprietary trading culture in his first bestseller, Liar’s Poker. In the ’80s, banks tasted the seductive elixir of trading their own capital. Clients were not treated like customers, but as counterparties or “muppets” to be exploited.
Traders were overjoyed to score a profit, or, as Lewis described, “rip off a client’s face”. There was a lot of face ripping going on in the early days of market making until more computing technology arrived.
So when a bank says they are incredibly ‘client focussed’, what they really mean is that their employees are ‘top notch’ professionals and have good client service – not necessarily that the client comes first.
Regulators adamantly want banks to stop creating more risky activities and ideas; they think derivatives are the equivalent of nuclear weapons. But human nature and markets always mean that clients want to take the risks that they want to take. And if one bank won’t take the other side of the trade then another one will. Regulators want to roll back the amount of OTC trading and force derivatives and structured financial products onto exchanges. Or, place a higher price on OTC trades.
The dirty secret global banks won’t confess to is that to some degree, proprietary trading still exists in banks within market making. It’s just buried in their large balance sheets and operations with arcane names like “facilitation trading”. Their purpose isn’t to take positions exclusively for the bank, but to service clients that require position taking. But even this activity offers momentary profit opportunities.
Dodd Frank ended proprietary trading by banks. Regardless, these trades will get done by non-banks like hedge funds. Indeed, in China we are witnessing that the centre of gravity of the financial world has shifted from banks to innovators such as Alipay.
In the Big Short the protagonists were warned that in a crashing market, “for every dollar they are about to make, families will lose their homes, jobs will disappear and economic misery will ensue”. That is melodramatic and inaccurate. Both winners and losers, buyers and sellers of the subprime trade that constituted the ‘big short’ were merely on opposite sides of the same coin of hypocrisy.
The subprime credit crash highlighted not only the familiar ghosts of fear and greed, which haunt and tempt every investor and trader, but the manifest structural corruption and failures within markets, governments and society.
Peter Guy is a financial writer and former international banker