When does trading become gambling?

Executive Summary

When trading for a firm’s own account becomes a major activity, it ceases to be ‘trading’ and becomes ‘gambling’ (Peter Drucker, 2002). This rings true to the banking industry from the various dramatically seen examples like the recent subprime crisis which has affected even banking behemoths like Citigroup, UBS and Bear Sterns. The lack of control and regulations in the banking industry make it seem as though these ‘investment banking’ activities run parallel to the trading and speculating done by hedge funds. What concerns the public and various corporations with huge stakes in these ‘super regional’ banks, is whether their interest in being safeguarded or neglected as profits from ‘trading’ seem to be more important than the risk of ‘trading’ for these financial institutions.

I.

Leading money center banks[i] have accelerated their investment banking activities especially in the trading of debt securities and stocks in the secondary market as they struggle to compete against other money center banks and smaller community banks[ii] across the globe (Peter Rose & Sylvia Hudgins, 2008). By purchasing corporate debt securities and stocks and reselling them, these banks aim on acquiring higher profits as shown in figure 3[iii]. Banks that invest in debt securities such as bonds and loans can earn interest on it according to the creditworthiness of borrowers (low credit ratings require a higher risk premium). Besides that, banks may also acquire fee income through servicing debt securities that are securitized, security underwriting, and brokerage services.

To research these issues, we would use historical investment banking activities and also the recent subprime crisis to understand the relationship between risk and return while at the same time studying the effects of investment banking activities in terms of its profits, risk and from the public perspective. Investment banking activities, especially the trading of debt securities and stocks is seen to be highly profitable in the past[iv]. This is shown through the historical data of Long-Term Capital Management (hedge fund) that boasted an annual return of 40% in its early years and also two hedge funds under Bear Sterns, an 84 year old investment bank that also gained double digit returns before their downfall.[v]

Recently, debt securities have changed hands in an increasing active secondary market (Anthony Saunders & Marcia Million Cornett, 2006). The banks transfers the ownership of the loans to other investors that are willing to absorb the risks to earn profits in a process we now call securitization[vi]. Moreover, any fee income earned under such buying and selling can be recognized as current income and also an off-balance-sheet activity compared to the interest earned on direct lending that is accrued over time (Anthony Saunders & Marcia Million Cornett, 2006). Other trading activities by banks aim at capital gains by holding long positions in debt securities and stocks for an extended amount of time with the bank’s excess reserves.

However, higher returns come with a tradeoff of higher risk[vii]. Investment banking activities contains both systematic and unsystematic risks. The types of risk involve include credit, liquidity, operational, reputation, capital, prepayment, call, and business risk.[viii] These types of risk are commonly seen in the debt security and stock markets. As an example, investing in risky corporate bonds expose the banks to credit, capital, prepayment, call, and business risk. Furthermore, by holding on to debt securities and stocks, the banks are exposing themselves further to market risk or systematic risk which cannot be eliminated through the diversification of assets.[ix][x] To make matters worst, most money center banks are also involve in securitization whereby loans of different quality (like home mortgages and credit card receivables) are group together and sold to other parties willing the accept the risk (Peter Rose & Sylvia Hudgins, 2008). Securitization increases the chances of the approval of subprime loans while exposing certain parties to high risk without them realizing it.

From the public point of view, a bank’s main purpose is to make loans to businesses and individuals and not to buy and sell debt securities and stocks. The trading of debt securities and stocks enhances the probability of moral hazard problems which is commonly highlighted in agency theory. The moral hazard problem occurs when the lender (depositor) runs the risk that the borrower (bank) will engage in activities that are undesirable from the lender’s point of view (Mishkin, 2007). In this case, the bank’s investment in risky debt security and stocks causes a moral hazard problem as it damages the bank’s ability to repay depositors should their investment plan fails. Furthermore, bank managers acting as an agent has an incentive to engage the bank in risky activities as the losses would be absorbed by the depositors and gains would be credited to their name.

II.

A corporation placing large deposits with a bank engaged in such activities would be very concerned about its funds. First, trading debt securities and stocks exposes the bank to not only non-systematic risk, but also systematic risks. Non-systematic risks can be avoided through proper diversification of financial assets and other risk management methods[xi]. However, systematic risk or market risk cannot be eliminated this way and thereby exist in the entire financial market. Should a financial crisis happen, banks holding illiquid financial assets such as corporate bonds, stocks, and securitized assets like collateral debt obligations (CDOs) and collateral loan obligations (CLOs) will find themselves facing a severe liquidity crisis.

Recent deregulation of the banking and finance industry has not helped to safeguard depositor interest. Further adding to the problem is the breakdown if the Glass Steagall Act in 1999 that used to separate commercial banking activities and investment banking activities (Stephen Cecchetti, 2006). Through many mergers and acquisition like those of Citicorp and Travelers Group, money center banks have emerged and are quickly developing their own investment arm. Lack of regulation in investment banking activities have also gave money center banks a free hand in conducting trading and speculating of risky debt securities and stocks without getting into trouble from authorities. One of the recent cases in trading scandals by banks were that of Nick Leeson who speculated on the Nikkei in 1992 and in a matter of 3 years garnered $1.3 billion of loses for Barings Bank (Frederic Mishkin, 2007).

Besides that, the wide span of control and complexity of money center banks makes their management a problem (Peter Rose & Sylvia Hudgins, 2008). The span of control determines how closely a supervisor can monitor subordinates (Richard L. Daft, 2008). Money center banks have more hierarchical levels and a wide span compared to smaller community banks. This adds problems to management as top managers are often disconnected from subordinates in lower levels. Furthermore, financial globalization have also brought further complexity to money center banks as they are not centralized in one country but are often scattered across the globe.

Another concern would be of the principal-agent problem which occurs when the managers in control act for their own interest instead of the interest of stockholders and stakeholders. A clear example of this would be Ralph R. Cioffi who managed two Bear Sterns hedge funds. Driven by the incentive of getting his performance fees, Cioffi used aggressive and highly risky investment strategies to boost return (Matthew Goldstein & David Henry, 2007). By dumping most of the hedge fund’s money into the CDO market, leveraging money to the maximum, and also neglecting his reserves, Cioffi basically signed the death sentence of the two hedge funds in his management while at the same time tarnishing the reputation of Bear Sterns.

The risk facing money center banks is very real even though their size, net worth, and global presence seems to provide them security and strength. However, almost every big financial firm has now reported substantial ‘trading losses’ (Peter Drucker, 2002). In some scenarios, these ‘trading losses’ have been heavy enough to kill the bank. From British Barings to New York’s Bankers Trust to Japan’s Sumitomo, we can see that trading and speculating involves high risk that will from time to time strike down another victim.

III.

Having known the various risk and possible scenarios of the trading and speculating done by money centre banks, our mind now run through the possible solutions in management that can be used to safeguard and govern funds managed by these financial institution. George Benston contends that financial-service institutions should be regulated. Hence, there is a need of strong regulations to safeguard the funds. Regulations should call for more transparency not only from banks but also from the bank’s customers. An example of this would be the Sarbanes-Oxley Act of 2002 that was established to regulate public accounting firms that audit publicly traded companies (Peter Rose & Sylvia Hudgins, 2008). The Sarbanes-Oxley Act basically calls for more corporate governance which is desperately needed in the industry. However, regulations do not prevent bank failures (S. Scott MacDonald and Timothy W. Koch, 2006). Regulations are unable to eliminate all risks from the entire system and it only serves as a guideline for banking operations which acts as external controls.

Another method to safeguard funds in banks dealing with investment banking activities is to diversify its portfolio of assets. Money center banks need to invest more in government bonds such as the US treasury bonds to diversify its portfolio into a more diversified risks distribution as government bonds are safer than corporate bonds. If the portfolio is well diversified, the funds tend to be less risky. A well diversified portfolio should contain assets that are low or negatively correlated. However, in the world of reality, it is hard to pool such assets into a bank’s portfolio. One way to solve this would be to use international portfolio diversification whereby the money center bank holds internationally issued financial instruments. It is not uncommon for an Asian economic expansion to take place in the midst of a US recession. However holding international portfolios will still subject banks to systematic risk.

Information technology should also be used to strengthen the links of communications in money center banks. Because of the wide span of control and decentralized geographical locations of these gigantic institutions, information technology can play an important role in their management. Information systems like Enterprise Resource Planning (ERP) can solve the problems of outdated and redundant information by collecting data from various departments and storing them in a single central data repository (Kenneth C. Laudon and Jane P. Laudon, 2007). Accurate and real-time information of trading activities can help top management to fully judge their risk positions and enable quick responses should there be any mismanagement of funds.

Lastly, management incentives should be carefully implemented so as to reduce the seriousness of the conflicts of interest in agency theory. Performance fees, bonuses, and commissions should be judged based on management prudence and performance instead of how much money a certain individual has earned for the company. According to Peter Drucker (2002), top management seems to have carefully looked the other way as long as trading produced profits and until losses becomes so big that they could no longer be hidden, the gambling trader was a hero and is showered with money. This greatly encourages risk taking and must be avoided so as to fulfill the bank’s fiduciary responsibility to their stakeholders.

Conclusion

Richard Dennis, one of the legendary commodity traders of our time once said that 95% of his profits have come from only 5% of his trades (Jack Schwager, 1989). The odds of money center banks in the secondary markets may also seem to be similar to those of the commodity markets. Money center banks should not make trading is major activity and turning ‘trading’ into ‘gambling’. For no matter how clever the gambler, the laws of probability guarantee that he will eventually lose all he has gained, and a good deal more (Peter Drucker, 2002). Instead, the top management of money center banks should closely monitor and screen investment activities and continue to emphasize on risk management.


[iv] A History of Hubris – Adapted from: Business Week, Not So Smart, 3rd September 2007

Time

Details

1980s

Junk-bond king Michael Milken of Drexel Burnham Lambert, who champions the high-yield corporate debt market and later pleads guilty to fraud, argues that the higher rates would more than offset any potential risk to the product.

1989

After defaults unexpectedly soar, the $200 billion junk bond market collapses, exacerbating the savings and loan crisis. Lincoln S&L fails.

1994

Backed by a dream team including Nobel prizewinners Robert Merton and Myron Scholes, Long-Term Capital Management opens, racking up annualized gains of 40% in its early years.

1998

When LTCM’s computer models fail to anticipate shocks like the Russian debt crisis, the hedge fund sheds nearly $5 billion in four months, prompting the Fed to arrange a $3.5 billion bailout.

1999

Embracing a “New Economy,” investors bid up prices on technology outfits and back brand-new ventures with little or no earnings.

2000

The bubble burst NASDAQ falls 34% in a month, and Pets.com falls.

2004

Fed Chairman Alan Greenspan praises the virtues of adjustable-rate mortgages and refinancing for the average homeowner.

2006

In the era of easy money, the subprime market reaches $600 billion a year, and leveraged buyouts hit $525 billion.

Present

The Mortgage flu spreads, infecting the credit markets and much of wall street.

[viii] Figure 5 Types of Risk MacDonald. S. Scott & Koch. Timothy W. (2006)

Type of Risk

Definition

Credit Risk

Associated with the quality of individual assets and the likelihood of default.

Liquidity Risk

Current and potential risk to earnings and the market value of stockholders’ equity that results from a bank’s inability to meet payment or clearing obligations in a timely and cost-effective manner.

Operational Risk

The possibility that operating expenses might vary significantly from what is expected, producing a decline in net income and firm value.

Reputation Risk

The risk where negative publicity, either true or not true can adversely affect a bank’s customer base or bring forth costly litigation, hence negatively affecting profitability.

Capital Risk

Refers to the potential decrease in the market value of assets below the market value of liabilities, indicating the economic net worth is zero or less.

Prepayment Risk

Risk specific to asset-backed securities because the realized interest and principal payments from the pool of securitized assets may be quite different from the cash flow expected originally.

Call Risk

Risk of earning a loss because it must reinvest its recovered funds at lower interest rates.

Business Risk

Risk that the economy of the market area they serve may turn down, with falling sales and rising unemployment.

[xi] Risk Management Method

Type of Risks

Risk Management

Credit Risk

Perform a credit analysis on each loan request to assess a borrower’s capacity to repay.

Bank investment restricted on investment-grade securities.

Liquidity Risk

Bank holding liquid assets

Bank will secure its ability to borrow at reasonable cost.

Operational Risk

Banks need to have strong internal audit procedures with follow-up to reduce exposure.

Banks identify and quantify potential losses by type of event and the line of business where the event has impact.

Reputation Risk

Banks responsible to ensure employees are well-train.

Senior management make sure regular and consistent assessments of internal controls are performed.

All transactional documents need to be review and strengthened as necessary and systems should be in place to deal with customers complaints.

Capital Risk

Refers to the potential decrease in the market value of assets below the market value of liabilities, indicating the economic net worth is zero or less.

Banks need to maintain a level of capital in order to meet the daily transactions purposes and meet unforeseen or uncertain environment.

Call Risk

Risk of earning a loss because it must reinvest its recovered funds at lower interest rates.

Business Risk

Risk that the economy of the market area they serve may turn down, with falling sales and rising unemployment.

Banks need to observe and keep the operation and banking business processes in a performing condition without experiencing system failure, if there is, should be quickly recovered.

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  1. […] to be ???trading?? and becomes ???gambling?? Peter Drucker, 2002. This rings true to the bankinghttps://jamesesz.wordpress.com/2008/05/16/banking-behemoths-when-does-trading-become-gambling/Pacific Continental Declares Quarterly Cash Dividend PR Newswire via Yahoo! Finance Pacific […]



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