SYSTEMIC FAILURE IN INVESTMENT BANKS / THE FINANCIAL TIMES ( A MUST READ )

September 15, 2011 11:00 pm

Systemic failure in investment banks

The timing of UBS’s $2bn loss at the hands of a single trader could not have been better for supporters of profound banking reforms such as those proposed by the UK’s Vickers review. It could also not have come at a worse time for European banks, again in the grip of uncertainty. We must hope that the former outweighs the latter.


Whatever else Kweku Adoboli, the UBS trader arrested in connection with the loss, has done, he has tilted the politics of banking regulation to the reformers’ advantage. The revelations come on the third anniversary of the Lehman Brothers bankruptcy. Everywhere, those who feel that bankers got away with reckless endangerment must be thinking: “There they go again.”


That is in part true, but only in part. Losing $2bn, an enormous sum of money, is a big scandal for UBS. But the number needs to be seen in context. It barely amounts to four per cent of UBS’s $54bn of shareholders’ equity. By itself, this is not large enough to break the bank – but the knock-on effects on UBS’s businesses might be – let alone the financial system. The global economy was wrecked not by supposed individual “rogue traders” but by a systemic and systematic failure to understand the exposures banks were consciously taking on – exemplified by UBS’s $50bn losses on mortgage-backed securities just a few years ago.


Moreover, the “rogue trader” label should be taken with a pinch of salt. It is not yet known what sorts of internal risk management rules at UBS were broken, if any. But that “Delta One” desks, such as the one Mr Adoboli worked on, can cause losses is evident. Placed in a grey area between proprietary and for-client trading, these desks deploy client assets to match certain benchmarks for their customers – tracking the price of gold, for example. Any excess profits generated by providing that exposure can be kept by the bank: a perfect incentive to take on extra risk with the bank’s own balance sheet. Whether or not Mr Adoboli broke internal rules or external laws taking such risks, insofar as legally possible, is what investment banks are set up to do. If “rogue traders” are a problem, “rogue activity” is a bigger one.


So the UBS scandal mainly confirms what we already know. The narrow lesson is that derivatives can conceal risk as well as manage it. The broad lesson is that inherently risky investment banking must not be allowed to contaminate utility banking or the wider economy. It is a call to speed up efforts to increase investment banks’ capital buffers and the ease with which they can be resolved if the buffers are worn through. If this is done, the risks investment banks take on and the gains and losses that ensue are largely a matter between banks and their shareholders – provided that shareholders are not defrauded or misled.


This, however, is not the situation we are in. The UBS scandal will have repercussions. Most obviously on UBS itself – with its reputation badly damaged by its subprime losses, this additional blow will make things harder for its private wealth management business. And by bringing home how little we know about the bodies buried in banks’ balance sheets, it will fuel scepticism of other banks – especially in the eurozone, where market pressures are intense (even if they lifted a bit after Thursday’s joint central bank intervention).


The biggest questions raised by the affair are for Switzerland. The country that prides itself on conservatism in dealing with money has been losing patience with the risk-taking culture of investment banks. It may find that even the “Swiss finish” to Basel III capital rules is not enough to protect its public finances against losses.

Cultures are difficult to regulate by edict, but they do evolve when the environment changes. To get investment banking culture under control, a good start would be for everyone to stop subsidising it.
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Copyright The Financial Times Limited 2011.