Thursday, May 24, 2012

Fighting big bank complexity is futile

In her Financial Times column, Sallie Krawcheck looks at the lessons learned from JP Morgan's trading losses and calls for a fundamental change in approach to regulation.

Specifically, she observes
Much of this commentary misses a crucial point: the size and risk of the trading position was identified to the management team by an outside party (the press) ....
Confirmation that there are market participants, other than the banks, that are fully capable of assessing a trading position.
Instead, JPMorgan’s trading loss points to the challenge of managing and regulating these incredibly complex companies. It is complexity that in good part defines Wall Street and forms some of finance’s highest barriers to entry....
It is complexity that over time has proved the highest hurdle. If other companies can’t understand your product or trading strategy, they can’t copy it, and excess returns can be sustained....
Confirmation of Yves Smith's observation that nobody on Wall Street is compensated for creating low margin transparent products.

As Ms. Krawcheck knows, complexity is a form of opacity and opacity is Wall Street's greatest source of profits.
In the main, the response from regulators to the perceived causes of the downturn has been to fight complexity with complexity....
If regulators engage with the banks and regulate topic by topic – to stop this exact scenario from repeating itself – Wall Street will innovate businesses and trades that overtake their efforts every time, in search of new pools of profitability....
Wall Street's ability to overtake the regulators is best illustrated by structured finance securities.

Wall Street created an entire business that by design was opaque.  The securities do not provide investors with all the useful, relevant information in an appropriate, timely manner so the investor can make a fully informed investment decision.
We need to shift the conversation in a fundamental way. We must discuss how much risk, of any kind, we are comfortable having our banks shoulder, rather than playing the proprietary-trading parlour game....
Regular readers know that the solution that does not fight complexity with complexity is to require the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

With this information, market participants can assess how much risk each bank is taking.  More importantly, market participants can adjust the amount and price of their exposure to each bank to reflect their assessment of the bank's risk.

This exposure adjustment is the market's way of telling bank management and the regulators how comfortable it is with the amount of risk each bank is taking.
The JPMorgan loss serves as a warning sign to make certain that we are fighting the right battles.
As it has been since the beginning of the financial crisis, the right battle is for requiring ultra transparency, particularly for banks and structured finance securities.

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