Regulation: The force will be with the rogue one
Amid all the calls for 2017 that get pumped out of research departments at this time of year, I have not seen any predictions for the return of the rogue traders.
And yet, if the rumour is true that president-elect Trump will repeal all that ‘boring’ financial regulation it seems to me that the return of balance-sheet-busting losses from individual traders is a racing certainty for a number of reasons.
First of all, banks will find it impossible not to return to proprietary trading if they are so enabled. Returns on equity for investment banks have been low – lower than the cost of equity in many important developed markets, and that is not sustainable.
It is unlikely the more complicated consensus around risk-weighted capital calculations and higher regulatory capital levels will be changed, at least not soon – and so, in other words, leverage will not be a strategy in the medium term. Compensation could be lowered but, let’s face it, it won’t – and probably couldn’t anyway to levels that would really make a difference.
So why shouldn’t banks use the very intelligent human capital manning their trading desks and clever research to make a few dollars or euros?
Makes sense, right? Which it will in many cases. And as banks re-absorb prop-trading risk, there will be some great returns made for banks. Headline-grabbing returns. These banks will point the way for the more cautious because the markets will do their thing: reward the risk takers with rising valuations and punish those scaredy-cats that do not rush to build up positions across the FX, rates and commodities universes. And soon everyone is doing it.
Skill does make up a part of trading success, but no one really knows how much and definitely not how sustainable it is
Then we are back to the fallacies of trading – but now supercharged by the backing and might of global institutions. One is that successful traders always believe they are the sole cause of their success; and the more successful their run, the more they believe it.
The fact is that, of 100 traders, 5% will have outsized returns by definition of distribution (maths even a non-banker can grasp), since trading is often just a function of distribution rather than skill. But those individuals – those 5% – of course think it is purely down to their own abilities, which leads to a more aggressive approach and more risk taking. But, in purely distributional terms, what are the chances that the top 5% in one year will be in the top 5% next year?
Of course, it is not purely random. Skill does make up a part of trading success, but no one really knows how much and definitely not how sustainable it is. So risk departments and compliance systems are designed to protect the downsides of individuals’ actions. Until those systems are gamed and break.
The other issue is that those skill sets change. It has been a long time since trading success was based on fundamental analysis (if it ever really was – although it seems churlish to deny it was a bigger determining factor in decades past). Recently the markets have gone up on good news and on bad news, as central banks have added their special QE sauce to the markets. So, to be (Dodd-)Frank, almost anyone with collateral could make money in the last five years.
The irony seems to be that these recent trading-certainty years were the ones the banks were not allowed to participate in. Just when they may be allowed back into the water, the wave machine has been switched back on. Political risk is now – more than ever in a generation – going to be a driver of the markets and asset prices.
Who is used to trading these market dynamics? It is not a case of being right on your financial and economic analysis if the rest of the market dumps on the breakout of war between Russia and Ukraine. Or a right wing electoral victory in France. Or a late night tweet from Trump to Putin.
So, it looks like we have all the ingredients for the return of the rogue trader stories – as banks need to boost their returns, the regulatory pendulum will be swinging back towards risky business and the tried-and-tested ‘fallible human versus compliance systems’ will play out again. And again.
How should investors in banks incorporate this tail risk into the otherwise rosy outlook for bank stocks? It will be impossible to identify where and when these rogue-trader losses will come.
Some consultants claim to be able to assess risk cultures and corporate systems that point to susceptibility of failures. But, in reality, idiosyncratic causes and the role that chance can play mean that trying to identify and avoid the individual banks that offer greater rogue-trading risk is futile.
No, the only real approach is to use one long-standing tenet of investing that has always held true: diversification gives you protection.