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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