Giving props to Wall Street’s risks

September 17, 2009

Wall Street would like you to believe that when investment banks take on risk they are largely doing it for the benefit of investors — maybe even you and me.

Bankers say much of the capital that their firms put at risk each day is to complete trades for big corporations, mutual funds, pension funds, hedge funds and university endowments. And contrary to the conventional wisdom, proprietary trading — bets made for a bank’s own behalf — is really just a small part of their business.

Lately, Wall Street’s captains of capitalism have been aggressive in pushing the “we take big risks for our customers, not for ourselves” line of argument.

That’s especially so in the wake of the public furor over the outsized trading gains at the big banks like Goldman Sachs Group, JPMorgan Chase and Barclays and even Citigroup, so soon after the collapse of Lehman Brothers.

The notion that risk is being taken for customers as opposed to for the firm’s own benefit is somehow supposed to make it seem more palatable and somehow less risky.

Still, for many, the image persists that investment banks spend a lot of time and resources gambling on stocks, bonds, commodities or currencies to generate fat profits and big bonuses. And there’s good reason for that image: Wall Street firms don’t break out the dollars they take in from client trades versus those generated by prop trading.

Yet from the perspective of Wall Street bankers, it’s perfectly logical to see much of their risk taking simply as part of trades for their customers.

Here’s how:

Let’s say a hedge fund calls up an investment bank and asks it to help buy a large block of shares, but it doesn’t want to pay much more than a given sum and intends to finance part of the transaction. That may force the investment bank to commit some of its own capital to acquire those shares in a series of separate transactions, so as not to create an undue spike in the stock’s price.

To protect itself from losing money, the investment bank may go out and enter into a number of other trades or derivatives transactions — all intended to reduce, or lay off, its risk of a loss on the customer transaction.

And in all likelihood those follow-on trades will prompt the investment bank to engage in a series of other trades to minimize its exposure to something going awry with those hedges.

At the end of the day, what looks like a simple customer order to buy stock on margin may end up creating a daisy chain of transactions that the customer wasn’t even aware were taking place. But in the mind of a Wall Street banker, all these follow-on trades are simply part of the process of completing the customer’s order.

Not surprisingly, some of these follow-on transactions can rake in sizeable revenues for a bank’s trading desk. That’s how an ordinary customer request to buy stock can generate revenues far in excess of whatever fees the initial trade may have produced.

Of course, if things go wrong, an investment bank can just as easily lose money on some of these follow-on transactions, and that’s why there’s risk involved in the process.

It’s hard to see what distinguishes some of these transactions from what an outside observer might label as prop trading — a group of traders sitting around with a pile of firm capital to do with as they please. But that’s not the way that bankers think about customer trades.

Maybe it’s all just a case of semantics, and trying to make a distinction between customer trades and prop trading is fruitless. Ultimately, maybe all trading activities by investment banks should just be viewed as risky.

The key to taming the giant banks is to put them in a position where they must turn away customer business because of the potential risk associated with all these follow-on trades.

One way to do that would be to impose hard-and-fast caps on the size of bank balance sheets, as it would deter them from engaging in transactions that add to their assets and liabilities. To avoid any unfair advantage, the caps on bank balance sheets would have to be agreed by regulators and policy makers around the globe.

But a balance sheet cap would be easier to impose and monitor than the increased capital holding requirements Treasury Secretary Timothy Geithner is proposing for global banks.

And better yet, a balance sheet cap would have the added benefit of fostering more competition between banks by driving some business to smaller institutions.


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what rubbish.

First off, it’s awry, not array.

Secondly: What is it about America and these periodic, populist witch hunts on Wall Street? It’s not the first time it has happened. Mr. Obama does not hesitate to launch attacks on stockbrokers, insurance companies and banks, all to satisfy the cretin class that voted him into power and to please his cheerleaders in the media, notably Mr. Goldstein. How pathetic.

= Gotthardbahn =

Posted by gotthardbahn | Report as abusive

Another option is to not give them a taxpayer-funded safety net. Banks that take irresponsible risks will go out of business. More sensible banks will turn away risky customers on their own, and they’ll likely be better able to responsibly manage the failed assets of the other banks.

So long as there is no strong disincentive against risky investing (i.e., if Wall Street knows they can keep the gains but taxpayers will absorb the losses), we’ll see another banking sector collapse once they figure out the loopholes. Balance sheet caps just make it tougher to manipulate the numbers, but does nothing to address the root cause of why banks are enticed to make risky decisions in the first place.

Posted by Nick | Report as abusive

I think you need to reconsider the argument based on the example. If a bank receives an order to buy stock for an account there is no risk for the bank except for the account walking away from the trade. This is called flow trading and is a riskless transaction for the bank. Any costs associated with the transaction are passed through to the customer. When banks take risk they are doing so for proprietary trading, their money, not customer money.

Posted by mike | Report as abusive

Demanding accountability = Witch Hunt?

Which one of these leading lights of Wall Street adhered to prudential norms while taking on massive exposures to securitized investments?

What efforts were made to see the credit quality of the underlying assets?

Exposures gone awry is THE norm with these fine leading lights of Capitalism. When the time comes to foot the bill for their excesses they go with a begging bowl and seek the shelter of the state? Surprising how socialism is good when it comes to them. Guess it must be to protect capitalism.

Read the interview of Lehman’s ex CEO. He is actually unrepentant. He further wonders why he was denied a bail out when all his peers got one. The concept of being accountable for his cow boy machismo seems unacceptable to him.

All of these guys are being molly coddled when they should be given the boot and thrown out. Is that a witch hunt? Wow!!

Posted by R | Report as abusive

Granted Wall St salaries appear high, however as long as they are based on performance, I say good for them, they earned it. It is no different for the average worker; perform well and raises, bonuses, & promotions will follow. Everyone has the option to invest thier retirement funds or savings in CD’s. But, like everyone else, the average person is as greedy as the next and they want that higher return and they look to the stock market for the result. Just as your mechanic isn’t going to keep your car running at peak performance for free; Wall St. isn’t going to do your investing for free either. Isn’t it funny when someone’s car breaksdown they curse the mechanic when the real problem is the owner didn’t check the oil and let it run dry. When everyone’s returns are up; no one pats Wall St. on the back. Times like these and a lynch mob forms on the front steps. I’d like to lynch the individual who’s annual income was at $30k and thought he could afford a $400k home. Shame one the salesperson/broker but double the shame on the individual who signed the note. Those are the people who need to be removed from the gene pool.

Posted by Mark E. Knauss | Report as abusive

First of all Gotthardbahn, 52 percent of the American voters is not “the cretin class.”

What is it about England that must bring politics into a purely financial investment discussion? Oh yes, if the British gov’t had not vetoed Barclays Bank purchasing Lehman before bankruptcy (as was their desire) perhaps this financial meltdown would never have occurred. Thank you England for allowing its self interested politics to disrupt the world.

Posted by Gary | Report as abusive

As long as Obama is their “sugar daddy” nobody will be accountable for their own dirty diapers. Most of today’s CEO’s are bull-headed and greedy. They want a reward even if they fail their task.

Posted by RL | Report as abusive

‘One way to do that would be to impose hard-and-fast caps on the size of bank balance sheets, as it would deter them from engaging in transactions that add to their assets and liabilities. To avoid any unfair advantage, the caps on bank balance sheets would have to be agreed by regulators and policy makers around the globe.’

Good luck with that. These ‘regulators and policy makers’ can’t even agree on the time of day.

Maybe you guys should look more closely at how banking is done up in the True North, y’know, that big snow-covered place sitting north of America. Your Number One trading partner and Number One energy supplier. Canada did not have a housing bubble, a credit meltdown, a subprime debacle and all this other self-inflicted garbage that you are currently trying to sort out. Our banks are large, well-capitalized and – gasp! – PROFITABLE. And that was achieved without pillorying senior bank management and over-regulating the talented traders who know how to play markets without getting carried away. Perhaps you could learn something here but, if history is any guide, you won’t bother. JMHO

= Gotthardbahn =

Posted by gotthardbahn | Report as abusive

This is not a solution, but a nice thought. In the future, all top 2% of earners at an institution must forfeit all their money earned at the institution in the last X years if they need bailout money. Or they should get locked up for 25 years if they require bailout money. As a taxpayer the government can then bail them out and I’ll gladly pay the extra taxes needed, as long as I see some fat cats locked up or flipping burgers at BK’s. Hanging them would be more just, but this unfortunately is not China. These greedy criminals put the livelyhood of millions in jeopardy, and don’t even try to say you could not see this coming or were not aware of the risks.

Posted by blackbean | Report as abusive

Posted by mike: September 18th, 2009
1:40 pm GMT:

If only it was that simple and treasuries had such clear guidelines, SOP’s and ethics.

Its all murky, the money entering the system as deposits/borrowings, exits the system as lending/investing/playing around money, and so the cycle goes.

There is interest turn and then there is fees. And then there is treasury profits. And then there is making money on the liability side of your balance sheet.

What a gold mine.

Posted by Casper | Report as abusive

if you want readers to believe your example–it should trace actual transactions, not just posit hypothetical ones. by and large, banks live on fees and interest charged for financing. derivatives more often are used to reduce risk and are successful at achieving that goal. to the extent that both primary markets—stocks, fixed income, foreign exchange and their derivatives (mostly options, futures and swaps) are liquid and tradeable, banks have profit potential by making prices to other users of these products and at times by taking a position in them. the risk attendant to these positions is determined by the banks’ allocation of risk capital to trading desks and its traders. properly monitored by the banks risk departments and the banks regulators, they should not be unduly risky. ironically last year’s dislocations were largely created by exposure to derivatives affected by the over-leveraging of the balance sheets of quasi-governmental entities Fannie and Freddie. Congress approved the expansion of their balance sheets without requiring increasing reserves proportionately.

Posted by jc | Report as abusive

Doesn’t anyone see the elephant in the room? Banks take big risks and make gains for the customers? All of it for the people, really? Where there are gains from trading there’s also the other side to the trade that LOSES. Whatever form that counterparty has, you can be pretty sure that (here it comes) – it has customers (read “real people”) at its foundation – as does everything when you boil it down!. Of course investment banks are going to pretend as if trading gains have some real economic value – they don’t, it’s just a big redistribution act. We’ve already had too many experiments with the miraculous (and always ultimately disastrous) value “creation” out of thin air…

Posted by boxer | Report as abusive

The US is going to get one big margin call one of these days and Obama will be hailed starter than all you critics. Leverage has exponential effects and when the growth can no longer be manufactered these institution will be caught swimming naked again. Learn your lesson!!!

Posted by Steph | Report as abusive

ank/client relationships are complex, with all degrees of risk and often with loss leading in certain areas like FX trading, which is what the snakes would point to to justify this stance of assuming client risk.

But you can bet your house that they make it all back in the more opaque trades and other areas where the client simply accepts that costs are paid, and if they get outwitted too often by the bigger, more sophisticated clients, watch the price spreads widen until the balance is restored in favour of the bank.

Every trader knows who those clients are and they price accordingly unless instructed to do otherwise for the \”bigger picture\”.

Risk accepting charities, my …!

Posted by GBear | Report as abusive

does the author even understand the example he gave????
First off, he is describing a hedge and theoretically, a hedge is supposed to limit gains or loss, not give extraordinary gains or loss seen currently and secondly, no matter what terms bankers used to justify the risk they take for customers which in this case, is called hedging, it is just plain risk-taking as obviously, a net positive/negative position was taken which create a huge gain/loss and not a hedge which will create a small net gain/loss. However, I agree with you that all trading should be view as risky. I suggest you refresh your finance 101 before writing crap like this. Even a freshman understand the concept of finance better than you and can outclass your arguments.

Posted by tay | Report as abusive

Ever notice when an “expert” speaks/writes on something you know a lot about you quickly find that most are not experts at all, but merely opinionated know-littles speaking out primarily to seek notoriety, publicity or increased sales or all of the above. Correct information seems to be their last concern, at least as much as readership is their first concern. This article is no different as it is distorted, poorly researched and slanted.

And these writers are no different, and nearly all have no idea what goes on in a WS front office, or even in the back, and have no business trying to understand it, much less write about it.

Posted by richard | Report as abusive

When will more people look at a calendar and stop blaming Obama for the Fannie Mae and Fredie Mac bailouts and the later larger Bank bailouts?

The bailout of Fannie Mae and Freddie Mac occurred on 7-26-08. The $700 bln rescue for the major banks was approved by the House on 10-03-08.

The outgoing president signed them both immediately.

But to be fair – the Democrats were most supportive of both measures. But the President didn’t have to sign them and could have used a variety of delaying tactics against the advice of his own Treasury Secretary and the Federal Reserve Chairman.

Posted by Paul Rosa | Report as abusive

The bailout didn’t cause the banking collapse. It was designed to stem the collapse once faith had been lost in the GSEs. Don’t just look at a calendar—look at recipients of funds when Fannie and Freddie were lobbying Congress to let them expand their balance sheets. Obama was one of the top recipients of Fannie and Freddie campaign contributions in that period…despite being only a junior Senator.

Posted by jc | Report as abusive

Ever notice how people are quick to blame either the Democrats or Republicans or the Unions or the average taxpayer/mortgagee for the failures of the private sector. The Fed basically blackmailed Congress and Senate, the outgoing Republican Administration and the incoming Democrat Administration with FUD – Fear, Uncertainty, and Doubt. The bottom line is that the Banks and Wall Street out-greed everyone from the Senators and Congressmen all the way down to the local $8.00/hr auto mechanic. A balance sheet cap is just more layers of crap with loopholes. Ya wanna fix it? Make Wall Street accountable for it’s screw-ups, not the taxpayer. If Goldman, Sachs, or CitiBank, or Lehman Bros. screw up, give them the guillotine, not cake. Let ‘em go down! We’ll survive just fine.

Posted by JC | Report as abusive

Many comments surround the idea of whether to make the banks have more capital or as the blog piece wants us to believe, limit the size of banks balance sheets….

But Mr. Goldstein misses the point….

‘Let’s say a hedge fund calls up an investment bank and asks it to help buy a large block of shares, but it doesn’t want to pay much more than a given sum and intends to finance part of the transaction. That may force the investment bank to commit some of its own capital to acquire those shares in a series of separate transactions, so as not to create an undue spike in the stock’s price.’

The problem Mr. Goldstein, is that the collaboration of these two entities to hide their activities (so as to not create an undue spike in the stock’s price) is not conducive to transparency in the marketplace. As long as they have the ability to continue to ‘mask’ this kind of activity, then the market is being manipulated…. How hard is that for you to see ??????

Posted by Edgy | Report as abusive

“Populist witch hunts?” “Cretin class?” The American public forked over hundreds of billions of dollars to preserve the lifestyle of a parasite class. We actually are cretins, for financing these imbeciles who demand a “heads we win, tails you lose” line of work. The big investment banks all have trading desks and, in some capacity run as hedge funds. We should have let them go under or put them into receivership rather than allow a few people who believe themselves to be financial wizards, but are actually overcompensated morons gambling in a casino to fleece us. I’m guessing some of the commenters here fall into that category. 700 billion towards scientific research would have paid dividends for society and the world, rather than a few whiny jerks.

Posted by Blehbleh | Report as abusive

There is no denial that banks take risks for the investors.The important point is that the risks must be manageable even if the investments go bad & should not lead to making the very institution bankrupt like Lehman Brothers seeking taxpayers money to rescue them or vanish.Do the same very banks when in good times pass on surplus money to the state treasury instead of frittering it away illogically high salary,perks & bonuses to their executives? Why the banks don’t find inbuilt provisions to withstand such critical situations without asking for state crutches?

Posted by vksaini | Report as abusive