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.

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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.

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