Are investment banks like nuclear power plants?
We don’t know the full details of how Kweku Adoboli lost $2 billion at UBS, but as I watch an industry in decline, an analogy springs to mind. Yesterday I had a long conversation with one of the former managers in the chain of command above Jerome Kerviel at Societe Generale. After losing his job in that debacle, he’s now a top trader at another bank.
After we had got through the formality of exchanging the phrase ‘déjà vu’, my friend recalled the lessons he had learned from Kerviel: the need to have an army of people in place checking and re-checking the minutiae of a large trading operation. “It’s a long list”, he said, reeling off the tasks involved in reconciling pricing and cash payments across a web of counterparties in listed securities, over-the-counter equity swaps and stock lending portfolios. For example, just to confirm that the documentation of a trade and its ostensible hedge have the correct timings to avoid multi-billion mismatches is a full time job.
I once visited a floor of people that did this for a living. At first sight it looked like any other investment bank trading floor, although slightly shabbier since it was a floor that clients and most journalists never saw. These people easily match the numbers of “front office” staff at investment banks, and if you want to cut costs at a bank, you have to cut them too.
Now think of what happens if you attempt to trim these overheads while trying to increase the profits generated by the remaining employees. That means competing more aggressively to launch exchange-traded funds, increasing the volume of derivatives and securities trades that have to be reconciled behind the scenes. If you look at market share and the size of its balance sheet, it would appear that UBS has been doing just that.
“More instruments, more complexity – that means more risk”, as my friend put it. He mentioned the Japanese earthquake and tsunami as an analogy of an extraneous shock that could overwhelm the safety systems you had in place. I quibbled with him over that – in banking, market volatility is generated by the banks’ drive to increase volumes, not natural phenomena.
It was the echo of the Fukushima nuclear plant that got to me. Those floors of “back office” or “middle office” staff are like the cooling water being pumped into a reactor. Don’t be surprised if reducing the flow contributes towards a meltdown. To achieve a “cold shutdown” of a typical bloated investment bank, the costs could be much higher than we think.