When investment banks hire risk-takers

By Felix Salmon
September 15, 2011
Matt Taibbi is quite right about the $2 billion of rogue-trading losses at UBS.

" data-share-img="" data-share="twitter,facebook,linkedin,reddit,google" data-share-count="true">

Matt Taibbi is quite right about the $2 billion of rogue-trading losses at UBS. Basically, investment banks hire for risk-takers; they shouldn’t be surprised when this kind of thing happens.

The brains of investment bankers by nature are not wired for “client-based” thinking. This is the reason why the Glass-Steagall Act, which kept investment banks and commercial banks separate, was originally passed back in 1933: it just defies common sense to have professional gamblers in charge of stewarding commercial bank accounts.

Investment bankers do not see it as their jobs to tend to the dreary business of making sure Ma and Pa Main Street get their $8.03 in savings account interest every month. Nothing about traditional commercial banking – historically, the dullest of businesses, taking customer deposits and making conservative investments with them in search of a percentage point of profit here and there – turns them on.

In fact, investment bankers by nature have huge appetites for risk, and most of them take pride in being able to sleep at night even when their bets are going the wrong way.

Taibbi is receiving some blogospheric pushback, because the term “investment banker” means two very different things depending on the context. On the one hand, there’s investment banking as in M&A advice and old-fashioned merchant banking. A typical sentence would be “traders have replaced bankers in the executive suite at Goldman Sachs”. And then there’s Taibbi’s meaning: investment bankers as opposed to commercial bankers, or people who work at investment banks rather than at commercial banks. These are the people that the Vickers report is scared of.

The fact is that old-fashioned advisory bankers are pretty irrelevant here: the big money in finance has always been where the balance sheet is. And balance sheet is used on the trading floor and in commercial banking. So let’s put the fee-based bankers to one side: it’s absolutely true that investment bankers tend to love risk, even as commercial bankers have historically shunned it.

I’m reading The Devil’s Derivatives right now, Nick Dunbar’s fantastic book about credit derivatives traders. (I’ll have much more on the book when I’m done with it.) In the introduction, he makes this distinction really well, introducing the hotshot traders he dubs “the men who love to win”:

This rare, often admirable, but ultimately dangerous breed of financier isn’t wired like the rest of us. Normal people are constitutionally, genetically, down-to-their-bones risk averse: they hate to lose money. The pain of dropping $10 at the casino craps table far outweighs the pleasure of winning $10 on a throw of the dice. Give these people responsibility for decisions at small banks or insurance companies, and their risk-averse nature carries over quite naturally to their professional judgment. For most of its history, our financial system was built on the stolid, cautious decisions of bankers, the men who hate to lose. This cautious investment mind-set drove the creation of socially useful financial institutions over the last few hundred years. The anger of losing dominated their thinking. Such people are attached to the idea of certainty and stability. It took some convincing to persuade them to give that up in favor of an uncertain bet. People like that did not drive the kind of astronomical growth seen in the last two decades.

Now imagine somebody who, when confronted with uncertainty, sees not danger but opportunity. This sort of person cannot be chained to predictable, safe outcomes. This sort of person cannot be a traditional banker. For them, any uncertain bet is a chance to become unbelievably happy, and the misery of losing barely merits a moment’s consid- eration. Such people have a very high tolerance for risk. To be more precise, they crave it. Most of us accept that risk-seeking people have an economic role to play. We need entrepreneurs and inventors. But what we don’t need is for that mentality to infect the once boring and cautious job of lending and investing money.

When you’re hiring people for the UBS trading floor, you’re hiring men who love to win, congenital risk-takers. And then you surround them with risk-management protocols designed to keep them under some semblance of control. There’s a natural tension there. And if you take the hundreds of thousands of risk-takers working on trading floors in London and Hong Kong and New York and Paris, it’s a statistical inevitability that one or two of them will go rogue every year or so.

Risk-managment protocols are important, but they can never be foolproof, because they’re run by humans. So we really shouldn’t let investment bankers — by which I mean risk-hungry traders with access to billions of dollars of balance sheet — anywhere near the systemically-important balance sheets of our largest commercial banks. Losses like the $2 billion at UBS are manageable. But they’re small beer compared to the entirely legitimate losses made by the likes of Morgan Stanley’s Howie Hubler during the financial crisis. He managed to lose $9 billion, and get paid millions for doing so.

Multiply that by an entire company, and you get Lehman Brothers, or Merrill Lynch. One of the great good fortunes of the financial crisis was that neither of them was attached to a commercial bank at the time; one of the great bad fortunes of the financial crisis is that the sins of Merrill Lynch weigh down BofA’s balance sheet to this day, and are in large part responsible for the fact that, still, no one really knows whether the bank is solvent or not.


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

The problem isn’t that the trader (he’s not a banker) lost $2 billion, it’s that the bank didn’t know about his trades. There is no excuse for that level of incompetence. Nobody at any level of any company in 2011 should be able to have $2 billion in potential losses on the books without anybody else knowing about it. It’s just not an amount of money that one person should be trusted with, especially when it is other people’s money, and some government will be expected to step in and rescue the bank should the losses threaten the survival of the bank. Don’t these folks look at their balances every night?

Posted by KenG_CA | Report as abusive

Thanks Felix

If Matt Taibbi had simply changed “Investment Bankers” with “Those who work at Investment Banks”, he would be covered from the “blogger pus-back” – as the latter term would also include traders who operate the in-house Hedge Fund Units of investment banks

It should be common sense to recognize an inherent difference between investors who accept the trade-off of “limited upside” coupled with “low downside risk” (traditional banking, bond investing, etc) vs those who prefer “unlimited upside with significant downside risk (traders, Hedge Funds etc). The incentive structure is different; therefore, the population that self-selects itself into the profession will be different. Of course, some may argue that fee-generating M&A investment banking is both low risk and high reward due to the standard “7% of the deal” cartel rate that commercial industry is always willing to pay, but that’s a different story

Posted by EconMaverick | Report as abusive

The trouble is, investment bankers betting other people’s money do much worse managing risk than investment bankers betting their own money.

Posted by MaysonLancaster | Report as abusive

This article is silly. Everyone knows that BoA is insolvent.

Posted by pessimist2 | Report as abusive

Good post Felix. It’s interesting one never hears of “unauthorized” trades that do well. One only hears of the ones that go pear-shaped! The investment-bank risk management experts I know believe it would have been impossible for the alleged “rogue” trader, Kweku Adoboli, to make $2bn of losses without the awareness of colleagues, including his immediate boss who I believe is called John Hughes. One view (also expressed by Matt Taibbi in his Rolling Stone blog post) is that it’s farcical for Adoboli to be singled out by the MMS as some kind of “rogue” trader. I think Taibbi is right to claim that the reality is he worked for “a rogue company”, which is part of a “rogue system”. Its entirely possible that the bank will succeed in “scapegoating” its chosen “rogue” and patch up its own reputation, with the possible connivance of regulators and judiciary. Who knows? I expand on some these themes here:- http://www.ianfraser.org/ex-ubs-trader-s ays-swiss-bank-was-probably-trying-to-co ver-up-its-losses/ and here http://www.ianfraser.org/rogue-trader-kw eku-adoboli-held-after-ubs-owns-up-to-2b n-losses/

Posted by xxyy | Report as abusive

@KenG_CA nails it: “The problem isn’t that the trader (he’s not a banker) lost $2 billion, it’s that the bank didn’t know about his trades. There is no excuse for that level of incompetence. ”

read my post today for more on that…

http://kiddynamitesworld.com/losing-2b-w ithout-anyone-knowing-about-it-is-much-h arder-than-you-think/

Posted by KidDynamite | Report as abusive

There is a fair bit of speculation over here in Switzerland where UBS is the largest domestic bank that this trader was betting against the Swiss Franc and got caught by the sudden intervention of the SNB. It wouldn’t surprise me if he had been betting on a steadily strengthening CHF and on a steadily falling USD. There will be more bruised traders as a result of that intervention I imagine but did they try to do anything illegal? Probably not.

Politicians are pretty angry because it wasn’t long ago that UBS was bailed out by some $60 billion or so from the public purse and it wouldn’t surprise me at all to see more moves towards ring fencing of domestic banking as in the UK. The feeling seems to be that they were assured that UBS had new and improved risk management structures in place – and then this happens.

As for your argument that the remuneration structures attract risk takers, of course that’s true – but the lack of any financial consequence for their actions if they get things wrong only magnifies the problem. It seems to me they get paid a big bonus if they do well, and a big salary if they don’t.

Back in 2008 I suggested an alternative remuneration setup for traders and the bankers who profit from their activities:
http://fifthdecade.wordpress.com/2008/09  /24/reforming-bonus-pay-for-long-termis m/

This would have built-in long-termism and included financial penalties for failure but it seems old habits die hard and nothing has really changed.

Posted by FifthDecade | Report as abusive

Except in the UK it was the commercial and retail bankers that destroyed their banks but hey who cares about facts?

Posted by Danny_Black | Report as abusive

>>”The pain of dropping $10 at the casino craps table far outweighs the pleasure of winning $10 on a throw of the dice.”

Say what you will about psychology theory (and I have a couple of degrees in the subject), this runs counter to theory and is demonstrably not true.

Posted by Curmudgeon | Report as abusive

“the big money in finance has always been where the balance sheet is” – eh? commercial bankers (we agree here) use lots of balance sheet and are incentivised to do so. m&a, corp fin ib’s use as LITTLE balance sheet as possible. tell me again who earns the bigger bonus – commercial or investment bankers?

Posted by Worsel | Report as abusive

In the UK the banks got into trouble because of the lack of liquidity following the sub-prime crash. Northern Rock pretty much only ever raised money to lend as mortgages through the money markets, while LloydsTSB was solvent until after the crisis when its US boss merged it with HBOS which had got into problems in the same way as Northern Rock. The majority of the mortgage market in the UK is still mostly under private control, unlike the US where it seems the two main movers both had to be Nationalised.

The over-riding fact is, Danny, that whichever way you look at it, sub-prime is the cause of nearly all of today’s financial problems, and we’ll be saying that for the next ten years at least.

Posted by FifthDecade | Report as abusive

Excellent post, Felix.
Welcome to “The Devil’s Derivatives” fan club.
When you get to author Nicholas Dunbar’s illuminating analysis of the role of derivatives in triggering the financial crisis, you should share a summary with your readers.
Perhaps you could do a Lego presentation about the difference between financial life on planet Earth vs. what happened on “planet Derivative,” as described in “The Devil’s Derivatives.”

Posted by CompactCar | Report as abusive

Hi Felix – I am usually a fan but really think this article is all over the place and that your opinions are quite wrong in many places – investment bankers (the corporate finance guys that work on M&A advisory, LBO’s, financings, etc) are actually the most risk averse people you will meet in finance. they all hope to rise the ranks from analyst or associate to managing director and end up managing internal politics than doing a good job for their clients. Traders are quite a different breed altogether. Investment bankers work for commercial banks (citi, bofa, barclays, ubs) – those investment bankers commit their balance sheets every day. when kkr calls and is looking to finance a $25bn LBO – the corp fin bankers get a call and have to package a financing deal that can earn up to $200mm in fees (just on the debt financing, let alone “advisory fees”, etc). The bankers do committ capital – regardless, I think that the key point is that UBS failed to simply measure their net eposure. Internally falsified records should be figured out immediately through a standard reconciliation of a book closing at the end of the trade. A trade was executed and cleared. the accounting for that trade cannot be frabicated against an appropriate reconciliation – UBS risk management and internal controls team needs to be terminated. senior heads should roll without hesitation. people worried about flying first class and what new hermes tie to buy on Bond Street or fifth avenue for the next meeting and forgetting they have a business to run – mediocrity and hubris is inherently embedded into the banker psyche.

Posted by puzzled | Report as abusive

FifthDecade, LloydsTSB didn’t have a US boss either in the sense of a company in the US or an american CEO or chairman.

NRK and HBOS and B&B got into trouble over vanilla commercial and retail banking loans that went bad. HBOS was a “victim” of a massive fraud – and i mean actual fraud, not a lazy rubber stamper not ticking all the boxes – that costs it billions of pounds in its SME loans operation. Absolutely sweet FA to do with investment banking.

Frannie were always what people seem to think IBs are, that is government back-stopped hedge funds where the profits went to the shareholders and management and the massive losses were socialised, yet weirdly they are the “victim”.

Posted by Danny_Black | Report as abusive

Which means that, Game master Jari Kurri, You never know a tiny little somethin in regards to playing golf some of the most important send align, Would be the actual other hand seat because within your click box and can run the ahead long run along with even when an additional admin functions safety the. The 4th guide this standard may possibly be the goalkeeper. Finland was being the on the innovative feeling goalkeeper motor coachs for everybody clubhouse competitors so this is smart.

Posted by traduceri daneza romana | Report as abusive