Former bank risk manager: should have let more banks fail and sent senior bankers to jail

The Guardian carried an interview with a former bank risk manager in which he made it very clear that in the aftermath of the financial crisis the regulators should have let more banks fail and sent more senior bankers to jail.

"I did derivatives almost from the start, late 1980s. Back then, it was "figure it out as you go". This has changed markedly. There are these levels of pseudo-knowledge, people holding PhDs who are far too trusting of their models. They are not using common sense. They ask: what does the theory say? 

"The problem with models is that often they don't take into account sudden spikes or collapses that have no precedent – as models are built on precedents. Overreliance on models is one problem in banking, another is the magnitude of the numbers. I catch myself writing down things like "600tn". Risk and control is huge, and getting bigger still. There are so many different product classes (shares, bonds, currencies, commodities, derivatives) and interrelationships, it is incredibly difficult to model or predict real outcomes....

One of the reasons for advocating that banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details is it focuses attention on both the order of magnitude of the exposures and the reliance on models.

Models that failed at the beginning of the financial crisis.

The classic example of a model that failed were the models that assumed that real estate prices always went up.  These models used the term HPA, house price appreciation, when the more appropriate term would have been CHP, change in house prices.  This would have convey that house price can decline.

"One of my fields has been equity derivatives [contracts that replicate the returns on stocks without actually having to buy or sell shares]. Most money made in the 1990s was from what's called "tax and dividend arbitrage". 

What that means is that we tried to exploit differences in tax regimes. For example, at some point the Italian government wanted to encourage foreigners to buy Italian shares. So they said, if you are a foreigner you get 140% of that share's dividend, effectively a subsidy. At the same time they decided that Italian nationals would get only 80% of that dividend, a withholding tax. 

A trader will look at this and say, right, I can arbitrage this. I will get a foreigner to buy the share, then effectively sell it to an Italian national via a derivative. Out of the 60% difference in dividend receipts, the foreigner gets 20%, the Italian gets 20%, and my bank gets 20%. 

"Sounds great, doesn't it? Except, of course, for the Italian government. So what happens when the government catches on? They create a massive backlog for any tax claims by processing them extremely slowly. That way inflation eats away at any gains. 

The end of this story is that the bank is left with a tax credit on its balance sheet which is, in effect, worthless. The only winner is the trader, who pocketed his bonus when the trade went through and who probably moved on to another bank years ago. 

The global banks have literally set up thousands of subsidiaries to facilitate 'tax and dividend' and similar arbitrages.

Requiring banks to provide ultra transparency would bring an end to this activity.  With ultra transparency, the banks would have to disclose what each of these subsidiaries was doing including its assets, liabilities and any off-balance sheet exposures.

The activity would end because bankers know that the sunlight shown on their arbitrage activities will quickly lead to a regulatory response.

"I am not a banker basher, but I don't defend them either. The compensation has got out of hand, I will say that. Bankers are not entrepreneurs or innovators. They are salary men who turn up at work, sit in a seat and pick up a salary. 

"I have often wondered about what makes a successful trader. There's such value in an institution's name. If you trade currencies for Deutsche Bank that means you will get a lot of business by virtue of Deutsche's platform and infrastructure – nothing specifically to do with your talent....

The former bank risk manager has identified the myth of financial innovation.

Bankers are not entrepreneurs or innovators who are creating low margin, transparent products that help the real economy.  Rather, bankers deliberately design and sell opaque products that maximize their ability to make money because they know the buyer cannot accurately assess the risk of or value these product.

As Yves Smith said, nobody on Wall Street was compensated for creating low margin, transparent products.

"The power to look after huge sums of money is entrusted to so few people. We need more financial literacy among the general public. 

One of the ways to "improve" the financial literacy among the general public is to bring transparency to all the opaque corners of the financial system.

Transparency improves the financial literacy among the general public because it allows the experts to do a better job of assessing risk and communicating their findings.

"The crisis. What happened is simple: banks provided cheap credit to individuals and governments, and kept doing that by packaging the debts as Collateralised Debt Obligations (CDOs). It looked too good to be true and it was. 

Banks worked out what rating agencies wanted and manipulated their models until they fitted and the agencies declared all that cheap credit super safe. 

I think the rating agencies deserve a huge portion of the blame. They have proven themselves universally useless.

With ultra transparency, market participants do not have to rely on the rating agencies.  Rather, they can independently assess or hire an expert third party to assess for them each financial product that they buy.

With ultra transparency, the rating agencies become just another expert offering their opinion on the risk and value of a financial security.

"What should have happened? We should have let more of the banks fail. We should have let the insurance companies who bought the CDOs fail. We should have let people who borrowed too much lose their homes – a home they couldn't afford in the first place. 

This is how people learn what risk is. When an Icelandic bank offers you a bit more interest than the UK bank, then it is because the Icelandic bank takes more risk. People need to understand this. If everybody who put their savings in the Icelandic banks had only been given 90% back by the UK government they would have learned a valuable lesson in risk versus return. 

"Would letting banks fail bring on a global meltdown? That's a tricky one. I'd say, since so much wealth is concentrated among the 1%, it will be primarily them who lose the most financially.... 

As your humble blogger has discussed on many occasions, there is a difference between a bank "failing" and a bank needing to be resolved.

A bank fails if it becomes insolvent and the book value of its liabilities exceeds the market value of its assets.

However, just because a bank is insolvent does not mean that the bank has to be resolved.  Modern banks are designed to continue operating and supporting the real economy even while they are insolvent.  They can do this because of the combination of deposit insurance and access to central bank funding.

A bank needs to be resolved when it can no longer generate earnings.

Policy makers should have let all of the banks 'fail'.  In failing, the banks would have been forced to recognize upfront the losses that on the excess debt in the financial system that they will ultimately realize after the long process of default and foreclosure.

By letting banks fail, the real economy would have been protected.

The solution? ... we need to punish and humiliate key figures. This applies across the industry. Some of the CEOs are like criminals who got off on a technicality. 

We should have chucked a few in jail, make an example out of them. You need to make these people's social standing go down and then the rest will be much more worried than just losing their job and retiring with a few million in their bank account....

At a minimum, when a bank 'fails' because it has become insolvent, financial regulators should have replace everyone on the Board of Directors and in senior management.