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?
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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.”
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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/
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