Trading wars: Worryingly, big banks are in danger of turning into little more than hedge funds

Date: Thursday, August 26, 2004

Trading wars: Aug 26th 2004- From The Economist print edition- Worryingly, big banks are in danger of turning into little more than hedge funds- WHAT is the difference between a global investment bank and a giant hedge fund? Very little nowadays, it seems. Both play financial markets. The perceived investment skills of hedge funds, which aim to generate handsome returns in bad as well as good markets, are the reason why they have attracted about $1 trillion from investors. Investment banks, too, have long made money from trading on financial markets. So it may seem that there is little cause for concern. In fact, there are real reasons to worry. Investment banks have always run trading desks of their own, but they once earned far more from other kinds of business—raising money for companies by selling securities to investors; giving advice on everything from tax to mergers; and acting as intermediaries in deals, from which they would take a fee. This spread of businesses offered them some stability and security. They are still in these businesses, but new technology and a flood of capital into the banking industry have meant that many are far less profitable than they were even a few years ago. For that reason, many investment banks—and commercial banks with investment-banking arms—have decided that trading is, after all, a wonderful business. They already seem to have forgotten the lessons of the late 1990s, when many reduced their trading activity because they thought it too risky. More worrying still is the fact that the bets which banks are now making in their trading operations are much bigger because markets are less volatile. In such markets bigger bets are necessary to meet profit targets. And in consequence the biggest worry of all is what happens to the world's financial system if and when a large bank or fund runs into trouble as a result of trading losses. Because banks and hedge funds tend to pursue similar trading strategies, any sudden change in financial markets could cascade through the banking and hedge-fund industry. It has happened before. In 1998, many banks were pushed to the edge when Long-Term Capital Management, a giant hedge fund, fell apart; a financial meltdown was avoided only when the Federal Reserve co-ordinated a bail-out by the fund's bankers. The level of speculation is greater now than it was then. Strangely, precisely how much greater is hard to say. Trading positions have certainly increased hugely over the past two years, and Deutsche Bank has been at the forefront of this trend (see article). The risk-management formulas used by banks, and approved by regulators, have allowed banks to increase their trading positions using the same amount of capital as market volatility has fallen. On top of that, they have bet more capital. Yet the true extent of their risks has been disguised by a peculiarity of regulation: banks are required to say what they earn from their own trading operations, but do not have to describe the nature of their investments in other firms. And they have declined to say how much of their capital is invested in hedge funds, thus disguising the extent of their risks. Lights! No action Most, perhaps all, of the banks now making a living by trading in the capital markets are “too big to fail”: that is, they can count on a government bail-out. Many also get cheap finance from deposits that are insured by the government. For both of these reasons, the temptation for them—and those of their employees that get fat bonuses from trading—is literally to bet the bank. A first step to reining in these bets would be to force banks to disclose their full exposure to trading by revealing how much of their capital is invested in hedge funds. A second, complementary step, mistakenly rejected by the regulators who sit on the Basel committee, which sets minimum capital standards for international banks, would be to force banks to raise a significant portion of their capital in the form of subordinated debt, rather than equity. The idea is simple: holders of bank shares benefit from bumper profits, and so are likely to tolerate banks taking on bigger risks. Holders of subordinated debt, who come low down the pecking order of creditors, gain little from bigger profits, but could lose everything if a bank has to be bailed out. They are, in other words, just the sort of risk-averse investors to keep a hawk-like eye on trigger-happy traders. (source: The Economist Newspaper and The Economist Group)