Nice dissection of common myths and simplistic solutions, though I worry whether his solution is also too simplistic.
http://www.forbes.com/sites/stevedenning/2013/03/21/is-jpmorgan-too-big-complex-to-manage/ E Radical Management Is JPMorgan Too Big And Complex To Manage? A theory… may satisfy the politicians’ need for a villain or scapegoat, but such a theory offers no useful guide to the solution to the problem. Hyman Minsky (1986) JPMorgan Chase [JPM] has been in the news recently, and not in a good way. We learned this week that in July 2012, the Office of the Comptroller of the Currency (OCC) downgraded JPMorgan’s management performance from “satisfactory” to “needing improvement”. To put that news in context, the OCC rating, “needs improvement”, was the rating given during the financial crisis in 2008 and 2009 to Citigroup[C] and Bank of America [BAC]. At that time, many inside observers considered those two banks to have been insolvent. Last week, the Federal Reserve announced that it found weaknesses in the capital-management plan that JPMorgan had submitted for this year’s stress tests and was requiring the firm (along with Goldman Sachs [GS]) to resubmit later this year. And also last week, the Senate released its report on the “London Whale” debacle in which the unit supposed to be protecting the bank against trading risk (whose daily “value at risk” was $67 million) ballooned to a loss of more than $6 billion. The report found that “risk limits created by the bank to protect itself were exceeded routinely” and “bank executives misled investors and the public.” JPMorgan has said that it is working on “fixes”. But is the problem deeper? Is JPMorgan simply too big and complex to manage? Are all the big US banks to big and complex to manage? What should be done? Light on these issues is shed by an interesting report from the Milken Institute, “Breaking (Banks} Up Is Hard To Do: New Perspective On Too Big To Fail”. The authors are James R. Barth and Apanard (Penny) Prabha. Professor Barth is among other things the Lowder Eminent Scholar in Finance at Auburn University and a fellow of the Wharton Financial Institutions Center. Wall Street Agrees: Break Up The Banks! The report notes that Wall Street implicitly agrees that most of the big banks are indeed too big and complex to manage. Thus the book value of the biggest banks, except for Well Fargo, exceeds the market capitalization of these firms. In other words, Wall Street is saying: the big banks would be worth more broken up, than they are in their current form. The report gives the figures at the end of the end of the second quarter, 2012. While the figures have shifted somewhat since then, four of the five banks are still under 1.00. Q2 2012 Today Wells Fargo 1.29 1.24 JP Morgan Chase 0.74 0.86 Goldman Sachs 0.70 0.85 Citigroup 0.44 0.64 Bank of America 0.41 0.57 The big US banks are even bigger than we think Another striking finding in the report is that the big US banks are considerably bigger than their accounts indicate. That’s because “generally accepted accounting principles” in the US (GAAP) allow banks to conceal trading in derivatives. The report’s graphic “shows what happens to the total assets of the 15 U.S. banks if derivatives are measured under the International Financial Reporting Standards (IFRS) rules rather than under U.S. GAAP. The most dramatic changes occur at the biggest of the big U.S. banks, which carry out a disproportionate share of trading in derivatives. As a result, several of those institutions suddenly appear to eclipse competitors in other countries if they are measured on the same basis. Indeed, U.S. GAAP treatment may be understating the assets of all U.S. banks on our list by a total of $5 trillion.” For most people, $5 trillion, roughly the size of a third of the US economy, is more than loose change. At first sight, one might be tempted to conclude: that’s great! JPMorgan has almost twice as many assets as its balance sheet shows. On reflection, one is more likely to ask: given that derivatives are what led to the financial meltdown in 2008 as well as the JPMorgan’s London Whale debacle, what other contingent liabilities are lurking in this $2 billion pile of possibly toxic assets? A recent article in The Atlantic concluded that, although JPMorgan’s derivative assets are “only” $2 trillion (based on OCC numbers), the notional value of JPMorgan’s derivative trading could be as high as $70 trillion, or one-tenth of the entire $700 trillion global derivatives market, which is itself ten times the size of the entire world economy. No one really knows, because we have very little information on what these $2 trillion in derivative assets ($70 trillion in notional value) consist of. That’s not only because GAAP rules do not require disclosure but also because the banks have been remarkably coy about revealing what they are up to. The Atlantic found that even a supposedly safe and conservative bank like Wells Fargo, when you burrowed into its annual report, got two-thirds of its profits in 2011 from trading in derivatives. Efforts by The Atlantic in December 2012 to obtain further information on the nature and extent of the trading that led to such extraordinary profits were unsuccessful. Bank executives declined to discuss the matter or offer any clarification of the obscure references to these activities in the firm’s annual report. Among other discoveries, it was hardly reassuring to learn from The Atlantic that the toxic off-balance-sheet devices, known as “special purpose entities” made famous by Enron, have re-emerged in Wells Fargo’s activities as “variable interest entities” (VIEs). In JPMorgan’s case, we know that, in the case of the gambling on a share index by the London Whale, the “value at risk” of $67 million ballooned into an eventual loss of over $6 billion. What we don’t know is: what other contingent liabilities are lurking there? Is size the real problem? Although “too big to fail” provides a catchy political bumper sticker, and JPMorgan provides a convenient scapegoat for politicians and regulators to beat up on, the Milken Institute report concludes that it’s not obvious that the size per se of a bank like JPMorgan is the critical issue: “The problem, of course, is that there is no bright line that enables one to easily distinguish between big banks that are or will become a systemic risk versus those big banks that are not or will not become such a risk. To the extent that the demarcation line is adjusted for individual banks of different degrees of “bigness,” the end result might once again lead back to a ‘too big to fail’ problem. “A potential weakness with limits on size is that they could reduce economies of scale, not to mention economies of scope, in banking. That could increase the cost of banking services. In this regard, Wheelock and Wilson (2012, p.171) found that ‘…as recently as 2006, most U.S. banks faced increasing returns to scale, suggesting that scale economies are a plausible (but not necessarily only) reason for the growth in average bank size.’ In addition, Hughes and Mester (2011, p. 23) found ‘…evidence of large scale economies at smaller banks and even larger economies at large banks.’” Even the liberal critic Paul Krugman is cited as a skeptic of the idea of breaking up the big banks. Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small—small enough that the Federal Reserve believed that it was O.K. to let them fail. And of course, the cause of the meltdown in 2008—Lehman Bros—was a relative small financial organization in financial terms and it was not a bank. It was the non-transparent linkages of its transactions to other larger banking organizations that caused the meltdown. The size of Lehman wasn’t the issue. Repealing Glass-Steagall wasn’t the problem Nor was the crisis of 2008 caused by the abolition of the Glass-Steagall Act. The Milken Institute report notes: … the failures of banks in the crisis are not well correlated with the end of the Glass-Steagall restrictions. Bear Stearns and Lehman Brothers both suffered failures, but both were essentially pure investment banks. By contrast, JP Morgan Chase combined investment and commercial banking but weathered the crisis well. The Volcker Rule misses the problem Meanwhile the apparently simple Volcker Rule (“no proprietary trading by commercial banks” has morphed into a regulations—still to be finalized—that might amount to 30,000 pages. Even if implemented, the Milken Institute report is also rightly skeptical on the likely contribution of the Volcker Rule: “It is not clear, for example, that proprietary trading was a significant factor in the recent financial crisis. The losses that led to problems at Lehman Brothers, Bear Stearns, IndyMac, Washington Mutual and other failed institutions were mainly connected to mortgage-backed securities and real estate, rather than to losses from the kind of trading that would be targeted by the Volcker Rule.” Building ineffective firewalls The thrust of the Dodd-Frank law is to build firewalls around the commercial banks to protect them against a possible collapse. Quite apart from the fact that the meltdown of 2008 wasn’t caused by a commercial bank (Lehman Bros was not a bank), building a firewall around $700 trillion secret derivatives market is like building a firewall around an unsafe nuclear plant. No firewall can protect against the direct and indirect effects of a meltdown of even a tiny part of such a gigantic bubble. Even if only a sliver of the market were to go bad, say, two percent, that would still be the size of the entire US economy. Cash-strapped governments are today in no position to bail out Wall Street yet again, even if they had the political will to do so. The derivatives bubble is thus a gigantic financial accident waiting to happen: it’s “the mother of all bubbles”, with the risk of a vast and horrible “nuclear winter” to follow. Banking regulation has failed Overall, the massive effort at strengthened legislation and regulation for banks since 2008 has failed. It’s not for want of trying. The effort has been huge: Draft Basel III regulations total 616 pages. Quarterly reporting to the US Federal Reserve requires a spreadsheet with 2,271 columns. The 2010 Dodd-Frank law is 848 pages The regulations may amount to 30,000 pages of legal minutiae What we have here is a problem of rapidly growing bureaucracy and controls. The regulations are adding cost and complexity to banking without providing the public safety that is aimed at. How much more regulation would be needed to keep us safe? 60,000 pages? 90,000 pages? More regulation isn’t the answer. We have to think through more clearly: what is the problem we are trying to solve? What is the best way to solve it? Changing the game: greater transparency The brute fact is that the massive effort at regulation and inspection and building of firewalls creates a semblance of protection but it doesn’t provide real protection. Devising more rules or having more inspectors chasing after rogues like the London Whale or even breaking up banks is a losing game. The real solution is to change the nature of the game. Social pests like the London Whale are like cockroaches under a rock. They exist and flourish in the dark. Lift up the rock and they scurry away: we can then proceed to clean up the space that they were infesting. $5 trillion is lot to be hiding under a rock. The root cause of the 2008 meltdown was lack of transparency. After Lehman’s collapse, no one could understand any particular bank’s risks from derivative trading and so no bank or shadow bank would deal with any other bank or shadow-bank. Because many of the banks and shadow banks had been involved to an unknown degree in risky derivative trading, no one could tell whether any particular financial institution might suddenly implode. That problem still exists today in JPMorgan and in the other big banks. The only real solution is to require this trading in derivatives to be conducted in public. Just as company shares used to be traded privately, it was found to be in the public interest to have shares traded publicly, so that everyone could see what was going on. Light is a wonderful thing. It is the opposite of the darkness that allows all kinds of skullduggery to flourish. What’s nice is that it wouldn’t require a massive bureaucracy to make it work. Market forces would do the job for us. Objections will be strenuous Obviously there will be strenuous objections to transparency in derivative trading from the financial sector. When the big banks are making two-thirds of their profits from secret trading derivatives, anything that might hinder that activity will lead to pushback. Banks will argue that “market-making” activities will be prevented by transparency. But is that a good thing or a bad thing? What sort of markets are being “made”? Yes, transparency would have prevented the London Whale from building up his massive positions, early in the process. The financial markets would have solved the problem, almost before it got started. There would be no need for inspectors or regulations or increased management oversight or new management fixes. The end of that kind of market would be a very good thing for everyone, including the banks. Transparency would facilitate legitimate derivative trading aimed at hedging real business risk, such as airlines wanting to hedge on oil prices, but would contain or eliminate activities like gambling on an obscure share index with the sole object of making money from other financial dealers. Derivatives trading of the latter kind is pure gambling. It is money trying to make money from money. It is Las Vegas writ large. The $700 trillion global derivatives market is the modern equivalent of the Tulip Mania of 1636 or the South Seas Bubble of 1720. It serves no social purpose. It should be exposed to the light of day so that it can be seen for what it is. If most of it withers and dies, so much the better. The world will be a better place. A change in focus for banks Fortunately for society, banks would be able to shift their top talent out of the gambling business and back to the banks’ core function of funding the real economy, i.e. increasing financial opportunities and reducing financial risk for an ever wider array of citizens and enterprises. Pursuing profits from trading in derivatives has distracted banks from their true social purpose of reducing risk and increasing opportunities for an ever wider circle of citizens and enterprises. Innovation has been taking place in banking, but not in a way that provides sustained benefits for either the banks or society. Banks must have one goal: adding value for customers. Shareholder value must be seen as a result, not the goal. Everyone in the bank must have a clear line of sight as to how their work is adding value to customers on a daily basis. Any jobs that are not adding value to customer should be eliminated. A change in focus for regulators: derivatives So let’s stop beating up on Jamie Dimon and JPMorgan for being too big and imposing ever more controls on activities that are inherently unsafe. That may make political hay, but it doesn’t solve the real systemic problem of the banking system. Instead let’s focus on getting to the root cause of the problem at JPMorgan and elsewhere: lack of transparency in derivative trading. Let’s use market forces, not bureaucracy, to solve the problem. Secret trading in derivatives: Is too large and complex to manage Is too opaque to be systemically safe Won’t be made safe by building “fire-walls” Is zero-sum, i.e. little value to society Would have huge social costs in a financial meltdown Would be too costly for governments to bail out Has significant opportunity costs for banks As Professor Barth told me today, “If you go through the annual report of a bank, you should not have to be a highly specialized financial expert to figure out where profits are coming from, or what degree firms are engaged in derivative activities, or what sort of derivatives or what sort of profit they are earning. You shouldn’t have to spend hours or even weeks trying to determine what is the ultimate source of the profits. If you don’t know the source of the profits, you don’t really know what is the business model. You’d like to think that investors could get information from annual reports to make investment decisions.” Thus regulators should do something that is both useful and cost-effective: they should require trading in derivatives to become public. And read also: Banks: From Bubbles & Nuclear Winters To Golden Eras Big banks and derivatives: why another financial crisis inevitable How can bankers recover our trust? Five steps that banks must take to create the good society The five surprises of radical management _________ Steve Denning’s most recent book is: The Leader’s Guide to Radical Management (Jossey-Bass, 2010). Follow Steve Denning on Twitter @stevedenning http://www.forbes.com/sites/stevedenning/2013/03/21/is-jpmorgan-too-big-complex-to-manage/ Sent with Reeder Sent from my iPhone -- -- Centroids: The Center of the Radical Centrist Community <[email protected]> Google Group: http://groups.google.com/group/RadicalCentrism Radical Centrism website and blog: http://RadicalCentrism.org --- You received this message because you are subscribed to the Google Groups "Centroids: The Center of the Radical Centrist Community" group. To unsubscribe from this group and stop receiving emails from it, send an email to [email protected]. For more options, visit https://groups.google.com/groups/opt_out.
