Still Too Big to Fail: A Crisis in the Works

The Dodd-Frank bill won’t be enough to stop Wall Street from risking it all and plunging us into another financial crisis.

On August 26, the New York Times joined other, nimbler media in reporting that Wall Street banks were working to frustrate the intent of the financial reform legislation. Proprietary trading (or, more precisely, its Avatar) has appeared in the form of client transactions which allow the banks to take risk-based market positions. It is the same behavior and the same traders, but in a different department.

Everyone who is surprised that Wall Street is beavering away to circumvent reform is invited to my next Saturday night poker game.

Revival of proprietary trading in technically defensible forms is unlikely to be the only tactic they devise. These traders are quite the clever guys and gals.

This prompts a question: If risk-based trading for account of the profit and loss of the banks lives on, did Dodd-Frank do enough to address the systemic risks known as “Too Big to Fail?” The answer is “no.” Systemic risk is inevitable. It can only be mitigated by capital requirements, limitations on risky behavior and procedures that might minimize chaos and more fairly allocate losses if a disaster occurs. These measures help, but there will always be an element of risky behavior encouraged by access to the government funds in an extreme circumstance. As long as banks are big and interconnected, failure might well be intolerable. The best answer is to prohibit imprudently risky behavior, or at least make it less profitable.

Luckily, there will be opportunities to further mitigate systemic risk in the coming months. In particular, Barney Frank has announced hearings for this fall on financial sector compensation. These hearings may provide a productive opportunity to revisit TBTF.

The noble efforts by progressive members of congress to limit the size of financial institutions were probably doomed from the start to failure. The Administration, the Fed and congressional leadership were fixated on the belief that size enhances competitiveness, profitability and, therefore, security against failures. This, of course, ignores that the failure of a large bank, by itself, is more cataclysmic than the failure of a small one.

However, the greater issue has always been a function of inter-connectedness of the modern financial system. Financial institutions are a bit like the Borg from Star Trek, a race of apparent individuals who actually function collectively as a hive. Banks appear to be discrete businesses, but there are so many interbank transactions and obligations that a single default can easily start a chain reaction. The real problem is less “Too Big to Fail” than it is “Failures too Damaging to Permit.”

Interbank transactions are essential. A primary purpose for banks is to facilitate free flows of money throughout the economy. A bank failure becomes a systemic problem when it causes the flow to stop out of fear that other banks might fail. Panics like this occurred in 1907 and in the Great Depression, and institutions like the Federal Reserve and the FDIC were established to address the risk. Nonetheless, it happened again in 2008.

Financial institutions are far less likely than other businesses to decline slowly into failure. Liquidity (ready access to cash) is essential to a bank. It provides credibility that the bank can meet the many obligations which are its stock-in-trade. A bank’s liquidity can evaporate instantaneously. If one source of liquidity develops doubts and reduces or eliminates credit availability, the other sources will often follow suit creating a death spiral. Facts are often less important than rumors. The proximate causes of the Bear Stearns and Lehman failures were more widespread rumors than demonstrable facts.

Trading activity poses the greatest risk to liquidity. The need for cash is large (theoretically infinite for most derivatives) and immediate. Recall that the axe fell on AIG when Goldman and other counterparties demanded cash collateral in amounts far beyond that which could be funded. They were concerned about the risk of future losses, not current ones.

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Because failure can strike a financial institution like a lightning bolt (especially one significantly involved in trading), the insolvency resolution provisions of the Dodd-Frank legislation cannot be the complete answer. These provisions can forestall panic among banks if one or more becomes troubled; and it certainly helps to restore order after a failure by providing sensible options. But interbank panics can be as uncontrollable and difficult to predict as an earthquake.

The inescapable truth is that the best way to address TBTF is by curbing risky behavior, principally trading. The financial sector will resist this by defending every trench and employing every tactic. Given the enormous trading volumes and the scope of derivatives traded, the opportunity to generate unbelievable profit is simply too large to abandon. Superior information technology, market intelligence and liquidity (as well as several less savory practices available to Wall Street) constitute advantages with which most market participants cannot compete. Trading is like printing money for these institutions, until they inevitably make a mistake and lose even more in one fell swoop.

Among the several tools available to regulators to curb imprudent risk-taking (capital requirements, margin, disclosure), compensation reform may be the most direct and effective. Anyone who has spent an appreciable amount of time observing a trading desk will conclude that sober maturity is not a trait common among traders. (That is not a criticism. Sober maturity would undoubtedly impede their job performances.) Because profits from trading under advantageous conditions are so immense, the magnitude of performance based bonuses has become an embarrassment. For a 30 year old, overly aggressive trader, this is like holding a bloody steak in front of a lion. It is likely to encourage risky and dangerous behavior.

The trader is behaving rationally: the immediate rewards probably do outweigh the uncertain future risks. Fault lies with the regulations and with unwise and short-sighted management (which may well not understand fully the complex risks taken on by traders).

Compensation reform will be resisted as unfair. Shouldn’t performance be rewarded? But much of the profit is reflective of inherent trading advantages rather than the skill and aggressiveness of the individual traders. I would hope that, in light of the financial crisis, we all agree that these advantages exist at the pleasure of the body politic. It would be completely defensible if, for instance, the financial institution’s tax deduction for trading performance based bonuses were limited.

It will be said that curbing compensation will squelch innovation. I suspect that even reduced compensation provides plenty of incentive. More to the point, all innovation is not beneficial. It is clear that, in derivatives trading, innovation has far exceeded social utility.

Hopefully, Congressman Frank’s hearings will be more than political show in an election year. He needs to consider the compensation of the leading executives. After all, these Captains of the Universe failed to see the inevitable failure of a market based on constant appreciation of residential real estate in an environment of stagnating and declining middle and low incomes, the principle determinants of home values. But trading performance based compensation needs attention as well. I begrudge no trader his or her second vacation home. But a second vacation retreat from the pressures of the trading floor cannot be justified if it is purchased by the presumed availability of the public treasury to cover the losses when the quantitative analysis turns out to be flawed.

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co. He is Visiting Scholar at the Roosevelt Institute.