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Banking & Finance

Investment banking practices, from unwise loans to the emphasis on derivatives, risk another financial crisis

  • Peter Guy says recent disputes in HSBC and Deutsche Bank highlight the banking industry’s disease of risking implosion to focus on big profits
PUBLISHED : Wednesday, 07 November, 2018, 3:02am
UPDATED : Wednesday, 07 November, 2018, 4:22am

It is hard to dispel the worry that there must be another financial crisis brewing as long as investment bankers believe that financial discipline and regulation only get in the way of profitable returns and great bonuses.

It’s rare in investment banking for an entire department to complain or mutiny because it’s usually easier to move to another bank than to reveal discontent. So it was a surprise that The Financial Times revealed in September that HSBC investment bankers claimed in a memo that its investment banking strategy had “utterly failed” and its “performance is really appalling”.

The memo, titled “Global Banking & Markets: Rewards for Persistent Failure”, says: “The division’s leadership has, year-on-year, utterly failed to create a successful strategy. We are entirely fed up and demoralised and have no confidence at all in the existing leadership.”

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Then, last week HSBC released strong third-quarter results. Adjusted revenue rose 9 per cent, pre-tax profit was up 16 per cent, retail banking and wealth management profit rose 25 per cent and return on equity for the first nine months was 9 per cent compared to 8.2 per cent during the same period last year.

At issue is the level of capital allocation priority given to investment banking – a broad practice combining advisory services like mergers and acquisition, capital markets and IPOs. This complaint is not a plea for excellence, but rather ignorance of past banking sins.

Only 10 years after the global financial crisis, a new generation of bankers is afflicted with a cyclical, greedy disease that can only be described as “to be paid partner-like pay without assuming partner-like risk themselves”.

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Last week, Deutsche Bank senior managers suffered an apoplectic fit of merger fever that its chief executive Christian Sewing had to douse it in the middle of discussing the bank’s disappointing third-quarter results. He snapped at speculation from his own top executives about a rumoured merger with Commerzbank.

A merger is a magic pill that would bolster Deutsche’s balance sheet and share price performance, which is trading at around 25 per cent of its book value. Most of all, future bonuses could improve with a stronger capital base to expand business.

This should stand as an indictment of post-financial crisis investment banking culture. Many pundits have been commemorating the 10th anniversary of the global financial crisis, wondering if the crisis could materialise again. Will it be scripted like a Greek or Shakespearean tragedy? As long as human beings are involved in the financial world, their propensity for ambition, folly and evil will drive the historical market swings between fear and greed.

Modern investment banking involves more than just delivering sound advice for clients. Much balance-sheet capital needs to be devoted to win business. In Asia, this could involve making personal loans to a mainland Chinese princeling to win an IPO.

Sources tell me that major banks have made these kinds of loans or “structured financing” to win business over the years. Some of those loans may never be repaid and have been internally shuffled from the investment bank to the private bank, where they are quietly buried away.

As 1MDB has shown, investment banks may give great professional service, but that doesn’t necessarily mean they have their clients’ interest as a top priority.

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Today, it is not realistic to compartmentalise commercial, retail banking, treasury management, IPO, equity and debt capital markets when their risks cut through a global balance sheet day in and out.

Expensive systems have been designed to track and manage the flow of credit risk through a balance sheet to prevent the next Lehman Brothers implosion. Yet they are only as effective as the bankers who make decisions.

Post financial crisis, global banks are still mired in an existential and cultural dilemma. Banks have strayed far from their traditional role as credit institutions and lenders.

They have generated a massive derivatives business that cannot be managed. Shutting it down amounts to financial blasphemy, setting off a crisis of purpose throughout the entire banking industry where so many activities hinge on derivatives.

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The traditional banking model was established on relationships rather than transactions. The derivatives charade that banks sustain today through “mark to market” will inevitably return to haunt governments.

And the source of the next crisis is not technological disintermediation, but the intermediation that banks say they must conduct. This exploitation of the risk and duration mismatch versus their (government-insured and guaranteed) deposits remains a perfect formula to privatise profits and socialise losses.

Peter Guy is a financial writer and a former international banker