Mike Beversluis

Wednesday, January 27, 2010

Halved bankers

Banchieri dimezzati by Francesco Giavazzi; Jan 23rd.

The problem of how to regulate banks is perhaps the most difficult market economy has ever had to dealt with. As all of complex problems, this admits too some solutions that are apparently simple, but most often wrong or ineffective. Minister Tremonti* wasted the occasion of the G7 presidency deluding himself (with the proposal of the "legal standard", book-keeping principles that would be the same for everyone) that it would be enough to force banks to apply new criteria when balancing their books. Most of the politicians, in Europe as well as in the US, went after popular approval claiming that the true problem were bankers bonuses. In reality they fell for a trap.

The most cunning among the bankers are happy when the issue of bonuses is debated (even if, evidently, they do not admit they are and apparently they protest). Bonuses often generate perverse effects. But discussing about bonuses avoids the question of what banks are or are not allowed to do, that is the discussion on rules that could make a dent in their profits. If the profits are large, a way to distribute them will be eventually found, whatever the rules on bonuses are. The proposals of President Obama put finally on center stage the true issue, that is that the same institution cannot be at the same time a bank (that collects savings and lends it to families and companies) and a hedge fund that is engaged in financial speculations. The quarterly reports of some of the large banks, published yesterday, show that most of the profits have been achieved by trading.

But in those quarterly reports there is no information on how many of those trades were made on their customers's account and how many on the opposite were made on their own account, with the bank's own capital, that is acting just like an hedge fund. Trades on their own account (that according to Obama's plan wouldn't be allowed anymore) are the most profitable, but also the riskiest ones. A bank should not be allowed to expose itself to the risks of a hedge fund. Because banks (as Alberto Giovannini is explaining since two years on the pages of the Financial Times, in columns that have influenced Paul Volcker, the man who drawed up the Obama plan) are also clearinghouses for trades: if a bank declares bankruptcy, the trades it has done on its own client's accounts risk to be nullified, that is, there is a risk of contagion spreading.

But there is another important difference, that explains why the bankruptcies of hedge funds have been exceedingly rare, unlike those of banks: if a fund registers a loss, the manager has to shoulder the costs, because he invests his own money in the funds he manages. This does not happen in a bank. But separating the two activities will not be easy, perhaps will not even be possible. Obama has to be credited with having started up a process and with having understood which is the right direction to aim to. Now the ball is in the hands of the Financial Stability Board, the institution which will have to translate these principles into concrete rules.



* Tremonti is the Italian minister of Economy and Finances.

3 Comments:

  • Definitely see the movie "Stock Shock" about hedge funds and short selling the market and the effect it had on Sirius XM stock in particular--short sellers ran it down to 5 cents a share at one point. On DVD only, of course--pretty much everywhere for sale or rent but cheaper at www.stockshockmovie.com

    By Anonymous Anonymous, at 27 January, 2010 12:04  

  • Worth tearing one's hair out over ;-)

    By Blogger John Travolta Sardus, at 27 January, 2010 14:38  

  • Bubbles seem hard to avoid - I can't help but think though, that a lot of the Big O's rhetoric is less about meaningful reform and more about saving his political skin. Where have we seen dark mutterings about "greedy bankers" lead before?? Too many people who made their own bad decisions want a scape goat.

    That aside, lots (and lots) of bankers did lose their jobs, and I suspect this will inculcate a risk-averse outlook far better than the stack of rules and regulations that Barney Frank's going to dream up.

    Also, Sirius and XM are weak, and have muddled through bad decisions, so they're fair game for short sellers. That's a favor they're doing us there, son.

    By Blogger Mike Beversluis, at 29 January, 2010 11:03  

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