Tuesday, March 12, 2013

Megabanks: too complex to manage

Having come across Chris Arnade, I'm currently reading everything I can find by him. On this blog I've touched on the matter of financial complexity many times, but mostly in the context of the network of linked institutions. I've never considered the possibility that the biggest financial institutions are themselves now too complex to be managed in any effective way. In this great article at Scientific American, Arnade (who has 20 years experience working in Wall St.) makes a convincing case that the largest banks are now invested in so many diverse products of such immense complexity that they cannot possibly manage their risks:
This is far more common on Wall Street than most realize. Just last year JP Morgan revealed a $6 billion loss from a convoluted investment in credit derivatives. The post mortem revealed that few, including the actual trader, understood the assets or the trade. It was even found that an error in a spreadsheet was partly responsible.

Since the peso crisis, banks have become massive, bloated with new complex financial products unleashed by deregulation. The assets at US commercial banks have increased five times to $13 trillion, with the bulk clustered at a few major institutions. JP Morgan, the largest, has $2.5 trillion in assets.

Much has been written about banks being “too big to fail.” The equally important question is are they “too big to succeed?” Can anyone honestly risk manage $2 trillion in complex investments?

To answer that question it’s helpful to remember how banks traditionally make money: They take deposits from the public, which they lend out longer term to companies and individuals, capturing the spread between the two.

Managing this type of bank is straightforward and can be done on spreadsheets. The assets are assigned a possible loss, with the total kept well beneath the capital of the bank. This form of banking dominated for most of the last century, until the recent move towards deregulation.

Regulations of banks have ebbed and flowed over the years, played out as a fight between the banks’ desire to buy a larger array of assets and the government’s desire to ensure banks’ solvency.

Starting in the early 1980s the banks started to win these battles resulting in an explosion of financial products. It also resulted in mergers. My old firm, Salomon Brothers, was bought by Smith Barney, which was bought by Citibank.

Now banks no longer just borrow to lend to small businesses and home owners, they borrow to trade credit swaps with other banks and hedge funds, to buy real estate in Argentina, super senior synthetic CDOs, mezzanine tranches of bonds backed by the revenues of pop singers, and yes, investments in Mexico pesos. Everything and anything you can imagine.

Managing these banks is no longer simple. Most assets now owned have risks that can no longer be defined by one or two simple numbers. They often require whole spreadsheets. Mathematically they are vectors or matrices rather than scalars.

Before the advent of these financial products, the banks’ profits were proportional to the total size of their assets. The business model scaled up linearly. There were even cost savings associated with a larger business.

This is no longer true. The challenge of risk managing these new assets has broken that old model.

Not only are the assets themselves far harder to understand, but the interplay between the different assets creates another layer of complexity.

In addition, markets are prone to feedback loops. A bank owning enough of an asset can itself change the nature of the asset. JP Morgan’s $6 billion loss was partly due to this effect. Once they had began to dismantle the trade the markets moved against them. Put another way, other traders knew JP Morgan were in pain and proceeded to ‘shove it in their faces’.

Bureaucracy creates another layer, as does the much faster pace of trading brought about by computer programs. Many risk managers will privately tell you that knowing what they own is as much a problem as knowing the risk of what is owned.

Put mathematically, the complexity now grows non-linearly. This means, as banks get larger, the ability to risk-manage the assets grows much smaller and more uncertain, ultimately endangering the viability of the business.