Banking risk and compliance: 'We should have let more of the banks fail'

'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'. Photograph: Matt Dunham/Reuters

He was in risk and control, the areas major banks set up to stop the "front office" bankers from breaking the rules and taking excessive risk. A working-class Englishman and veteran of several decades in the City, he is confident and soft spoken, with a mischievous smile. Currently working in a Treasury function looking at funding, liquidity and collateral costs across the investment bank.

 

"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.

 

"I didn't like the internal politicking in big banks. I used to be slightly bitter about colleagues who lacked the technical knowledge but still got ahead. Only over time did I realise that there are other valuable skills in an office context. Making sure that something is actually approved by getting different people to agree, smoothing over seams … It's a different skill set. The thing with risk and control is that it's impossible to put a number on a loss you averted by saying "no" to something. Meanwhile when a deal goes through, the trader can put a number on the profit generated.

 

"The divide in treatment of trading and support functions is immense. For a number of years I sat on the trading floor, as part of "support" monitoring risks. A telling anecdote: We would go to play football, traders and support, after work. One time we were late, so we took taxis. The traders could claim that through expenses without a second thought, but we couldn't. It was only a few pounds, obviously, so it was all about the symbolism. We refused to pay, causing a huge headache for various managers who had to blame each other for the need to enforce this petty rule. This went on for weeks before we paid up.

 

"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.

 

"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. Here's an idea: Yellow taxi-cabs buy a medallion which gives them the right to tout their wares in New York City. Why shouldn't we put a function like "Head of derivatives trading at Deutsche Bank" up for sale? What would that trade for?

 

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

 

"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.

 

"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. Besides, the path chosen has meant that many people did suffer from the crisis and, let's keep some perspective, the hardship in western economies is nothing compared to life for the poor in a place such as India.

 

"I notice you're always asking interviewees about the next crisis, where another black swan may be swimming. It's hard to say, but I'm sure it will be loan-related not derivatives – it always is. Maybe student loans that turn "bad", meaning people stop paying them back. Maybe the Private Finance Initiatives. Maybe a crisis brought on by short-selling [when a hedge fund borrows shares from a pension fund and sells them, waits for the share price to drop and buys them back, returning the shares and pocketing the difference].

 

"What I find truly scandalous in how short-selling works is the impact on the real pension fund investors. The pension fund managers invest your and my pension contributions in shares because they believe they will go up. The fund manager then lends the stock to a hedge fund that is trying to drive down the price. How can that be in my best interests? These pension funds are my money! Now, you may argue that these pension funds receive a fee from stock lending which boosts returns. This is true and brings me to my second point: who gets those fees? Often it's the investment bank facilitating the short-selling and the pension fund manager. The investor might receive only 20% of the fee, the rest goes to the intermediaries, the commission takers.

 

"I hope the next big scandal is exposing the fund manager industry. Their fee structure is completely opaque. I reviewed my own pension returns and discovered it had grown only very modestly over the past two decades. Not because the markets went down but because so much went in fees.

 

"Fund managers are worse than investment bankers. The solution? Again, the public must become far more aware and literate. And 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.

 

"I'd be in favour of publishing banded salary scales in all company accounts for all employees. And I'd like to see a Tobin tax on financial transactions. We've had a stamp duty on UK shares and that never stopped people from investing in British companies. Meanwhile a Tobin tax would stop a lot of high frequency automated trading and fund churning that serves no social purpose.

 

"How the industry has changed: there's far less honour. And there is far more diversity. I remember how back in the early 1990s we had this influx of Australians and New Zealanders. Backpacking students who wanted to work so they could travel. Then came the South Africans in the late 1990s and more and more Europeans. Now it's people from the Bric countries [Brazil, Russia, India and China] … many of them PhD quants (maths wizards). The City of London has become a different kind of place, more money-centric, and this attracts a particular type of person. The latest wave is from places very different from here. This has nothing to do with race, mind you. In the Bric countries there's a different attitude to bribery, rule of law, ethics … If you look at the names in recent scandals, they are from all over the world but there are few Wasp names [White, Anglo-Saxon Protestant].

 

"I don't think many analysts or people in the media understand a bank's balance sheet. They say, RBS's balance sheet is larger than the UK economy. But a GDP number for a country's economy measures something different than a bank's balance sheet. Also how accounting works is not helpful for outsiders. Say, I lend you 50 and you lend me 49. A bank's balance sheet will record that as 50, not as 1. This way, you get to a trillion pound balance sheet very quickly."