Author: David Korslund

On occasion a simple sentence in a longer analysis captures not only the core issue being discussed but provides a solid framework for thinking about finance in general. Such was the case in an essay from Paul Krugman in the 20 May 2021 New York Times. In a very clear and insightful discussion on bitcoin, Krugman asked a very simple question: “What problem does this technology solve?” He expanded on that simple question as follows: “What does it do that other, much cheaper and easier-to-use technologies can’t do just as well or better?” Refining his initial question to: What problem does this financial product solve? pivots his analysis to be a very valuable framework for looking at finance and banking. Focusin on meeting real needs rather than invented needs use to generate profits to pay bonuses would certainly push finance and banking in a healthy direction.

The importance of Krugman’s analysis was reinforced in today’s Financial Times in an article on bitcoin. That article was focused on the value of bitcoin but not once raised the issue of why is bitcoin relevant or what problem does it solve. Perhaps it is time for the financial press to use the common sense of Krugman as they write about financial innovation.

Occasionally there is an article that captures very well so many of the themes impacting banking and finance today. A recent New Yorker article covering Robinhood, an online trading platform is such an article. And the story is told using the lives of real people who faced real consequences from their involvement with finance – including a suicide.

Robinhood is a “zero-commission” trading firm that according to its own publicity has a mission to “democratize finance for all.” As noted in the article: “A Robinhood spokesperson said that attracting users who had previously been excluded from the financial system is a ‘profoundly positive change,’ and that ‘suggesting otherwise represents an élitist, old way of thinking.’ As noted in the article by the CEO of a competitor, Robinhood is “. . . the first company that introduced premier user experience and design in a mobile application to finance, and they also dramatically lowered the cost of investing,”

The mission of a democratic financial system is one held by many banks that practice values-based banking. Therefore it would seem that Robinhood’s actions would be supportive of values-based banking. But as one digs deeper into the practices of Robinhood a different story emerges. A story that aligns more with the traditional “greed is good” associated with Wall Street.

Although appearing to be commission free, as everyone knows there is no free lunch. So how does Robinhood generate revenues if not by charging commissions for trading? They do so by a practice called Payment for Order Flow (“pfof”). The trades made with Robinhood are directed to brokers who pay Robinhood a fee for that activity. As noted in the article: “Payment for order flow is common among brokers, but it is controversial, because it appears to create an incentive for them to send their customer orders to whichever market maker is willing to pay them the most.” The article further notes: “In exchange for access to the orders, the firms pay rebates to the brokerage company that routed the orders to them. The rebates and the skimming are invisible to the customer placing the trade order.” So it would appear that the commission free trading is funded through execution at prices that are not the best in the market for the buyer or seller of shares. As noted in the article even after controversy, “in the first quarter of 2021 Robinhood’s pfof revenue was three hundred and thirty-one million dollars.”

But the motivation of the users of Robinhood is also of interest. Their motivation seems to be often related to the issues that arose from the financial crisis of 2008 so many years ago but sill impacting banking, finance and politics. Some of the users of Robinhood see it as a means to get revenge for a financial crisis that impacted their families very personally. Those stories as reported in the article surfaced on chat sites focused on trading. As one individual wrote: “I remember when the housing collapse sent a torpedo through my family. My father’s concrete company collapsed almost overnight. My father lost his home.” Around the same time, the author claimed to have seen “hedge funders literally drinking champagne as they looked down on the Occupy Wall Street protesters.” The poster said that, as a result of the loss, his father had descended into alcoholism, and existed as only “a shell of his former self, waiting for death.”

This theme was taken up by one of the key characters in The New Yorker article had a similar family experience. He wrote in response to that post his reasoning for holding a position in Game Stop: “This is about more than just money, it’s about fucking these hedge fund managers until they understand what we’ve all gone through because of them. I am holding to ensure my parents can live comfortable lives at the expense of the assholes that almost cost them their lives. This is for you, Dad.”

But underlying all of this story is a fundamental misuse of the financial system. No where in the story is there a discussion of how Robinhood, various other institutional investors or the individual investors were thinking about how money should be used to finance productive assets. Rather the focus is on finance as a casino. And as we all know, betting in casinos is a losing proposition for everyone except the casino owners. Or in this case the financial companies that are running a casino and not investing in addressing the needs of society.

In the current economic climate and in times of rapid technological change, banks are facing unique challenges to their business models. This challenge is especially large in Europe where profitability of banks has been under attack for many years. For many years some European banks have tried to compete with the US investment banks – in some cases by purchasing them. But the recent events surrounding Archegos suggests that they have not been successful in using these new banking opportunities to create profitable sources of not only revenues but also net income for their stakeholders.

A recent series of articles in the Financial Times highlights this conclusion. The first article on 6 April noted that the collapse of Archegos cost Credit Suisse a $4.7 billion impairment charge in their prime broking activities. The article goes on to note: “In theory, prime brokers hedge all exposures, making only a modest margin on their activities. In practice, hedges are rarely perfect. Bonus-hungry bankers can find ways to exploit that.” The article also highlights that Credit Suisse is not the only bank active in this area.

The second article on 20 April goes further to note that Credit Suisse had substantially reduced its risk management capability in the run up to the Archegos debacle as well as the losses it incurred on Greensill. Whilst these losses have led to the departure of several senior managers (and one board member) responsible for risk management, that is a a bit like locking the barn after the horses have been stolen. The article noted that “six current and former Credit Suisse managers said the bank hollowed out risk expertise and trading acumen in favour of promoting salesmen and technocrats. Dissenting voices were suppressed, they said.” As anyone familiar with banking knows, suppression of dissenting voices is almost always the start of a downhill trend.

In an article on 27 April the Financial Times provided an update on the Archegos situation noting that total bank losses on Archegos were likely to exceed $10 billion. Interestingly all these losses were at non-US banks. It would seem that the US banks had in place much better risk management systems that allowed them to exit their exposures with minimal losses.

Finally on 3 May the Financial Times reported that the revenues (not net income but only revenues) on the Archegos relationship were just Swiss francs 16 million in 2020. Clearly a business model that faces potential losses of $4.7 billion for revenues of around $17 million is not sustainable. The only good news from this article comes in the following statement from the new Chair of Credit Suisse, António Horta-Osório:  “I firmly believe that any banker should be at heart a risk manager.” Clearly a signal of new times at Credit Suisse.

The large amount of liquidity in the current market has led to some unusual stories – stories that too well illustrate why the financial world easily loses touch with reality. The story of Hometown International, Inc. is told with humor and insight in a recent short article in The New Yorker. The article details how a small deli in New Jersey chose to go public including refusing to state that they were a shell company since after all they were an operating business. A deli with average sales of about $80 per day. The New Yorker goes on to test the deli’s pastrami sandwich to see if there was a “special sauce” that made it worth $2 billion at one point but later returned to a less stratospheric level of $100 million.

More information on the financial activities was available from an article in the Financial Times. This article noted that included in the investors of Hometown International, Inc. were the endowment funds of two major US universities, Duke and Vanderbilt. These investments appear to be made by an Asian asset manager on behalf of the universities. It would also appear that the ultimate goal is to use the entity to be a cheaper version of a SPAC (special purpose acquisition corporation).

Many bankers claim that all this innovation is good for the overall economy but is that so or merely a chance for bankers to make fees that can be used to pay their bonuses? And is it responsible for university endowment funds to support this type of speculative activity?

On 19 April 2021 the European Central Bank released its review of the reliability and comparability of  internal risk models used by the larger banks for their risk weighted assets. Although the summary headline on their website seems to be a relatively positive message, digging into the details suggests that there are real issues in the use of these models. The review of the individual bank models “resulted in a 12% increase, or about €275 billion, of risk-weighted assets for the investigated models” which reduced the capital adequacy for these banks by 70 basis points. That is not an insignificant change in the capital levels.

There are of course two questions that remain open. The first was well captured in a speech by Andrew Haldane in 2012 at Jackson Hole, Wyoming, USA titled “The dog and the frisbee.” This speech is well worth reading on a regular basis. In looking at risk models, the research behind the speech comes to the following conclusion: “Complexity of models or portfolios generates robustness problems when understanding a complex financial system over plausible sample sizes. More than that, simplicity rather than complexity may be better capable of solving these robustness problems.”

The second question relates to the fundamental nature of human beings. Or rather foxes. Do we want the foxes in the banking system guarding the henhouses (e.g. risk and capital adequacy)?

Yesterday a coalition of investors with more than $11 trillion in assets under management called on banks “to set enhanced net zero targets for 2050 or sooner with interim targets to be included, scale up green finance and withdraw from projects that fail to meet Paris Agreement goals.” The Institutional Investors Group on Climate Change issued this demand via a press release that is available on their website. This call to action is just another example of the rapidly increasing pressure on banks to align their financing with the need to meet the Paris Agreement goals.

Of interest is that among the investors, there are also many asset management arms of banks or other financing sources. These include Fidelity, Handelsbanken, KBI, Nordea, Northern Trust, PIMCO, Robeco and SEB. It would be of interest to note if the asset management arms are putting the same pressure on their internal financing activities as they are putting on other financial institutions.

In any case it is clear that banks and asset managers must take seriously the goals of the Paris Agreements and ensure that their financing activities are aligned with meeting those goals.

About one week ago I wrote about Credit Suisse and the issues they were facing that has led to reduced bonuses for the very top of the bank as well as the loss of employment for many responsible for the activities that have led to losses. Today the Financial Times reported that these losses have led to a reduction in the bonus pool for all of its staff – an estimated reduction of $600 million in the bonus pool. As noted in the FT article: “(I)ts top executives face a dilemma over paying out bonuses to support staff morale, while shareholders nurse losses tied to the fallout from Archegos and Greensill.”

This dilemma highlights an important change in the investment banking culture that has arisen from the shift from an ownership form that was primarily partnerships to one that is primarily publicly owned banks. That shift in ownership structure occurred more or less simultaneously with the end of Glass-Steagall in the United States and the Big Bank in London. Whilst much of the criticism over the current structure of the financial industry focuses on those two changes, it could be argued that the end of partnerships are just as responsible for the excesses and problems that arise in the financial system.

Under a partnership gains and losses from business were shared among the partners. That approach built into the business a natural risk management function as partners and those seeking to be partners acted responsibly to curb risk activities that could lead to losses. The current structure with public ownership eliminates that natural (and one could argue more effective) form of risk management. Under public ownership the upside goes to the staff (or at least the highly paid and powerful members of staff) and the downside goes to the shareholders. If the problem is serious enough the downside is covered by public funds to ensure that a too big to fail bank survives.

So as we look for solutions to the underlying issues facing the banking industry, perhaps a return to true partnerships for investment banking activities should be considered.

A large network of central banks that takes seriously the issue of climate change has developed over the last few years . The Network for Greening the Financial System has nearly 90 members and 13 observers. This network covers all major financial regulators and many multi-national financial institutions. As noted on their website: “The Network’s purpose is to help strengthening the global response required to meet the goals of the Paris agreement and to enhance the role of the financial system to manage risks and to mobilize capital for green and low-carbon investments in the broader context of environmentally sustainable development. To this end, the Network defines and promotes best practices to be implemented within and outside of the Membership of the NGFS and conducts or commissions analytical work on green finance.”

This network has a variety of work streams and provides resources and reports to support banks seeking to be proactive in addressing climate change. In a recent report issued in March 2021, current market dynamics relative to sustainable finance were analysed leading to five key takeaways:

This list is a very useful summary of the work that needs to be done. Hopefully the network and its members will immediately begin addressing these issues in their daily work. Hats off to regulators who are leading to develop a financial system that addresses the key issue of our time: climate change. Now it is time for the banks they regulate to also step up their actions in this area.

A recent article in The Economist regarding China’s approach to Hong Kong had within it a hidden pearl of wisdom. Whilst overall critical of the Chinese policy in Hong Kong, there was also a focus on the impact on the financial sector in Hong Kong. The financial sector has a business model that is traditionally “Western” in its orientation with the goal of being part of the international “free market” and “Neo-liberal” system. But does that business model deliver results for society?

As noted by The Economist, Chinese leadership has “an ideological distaste for high finance among party bosses who see the proper role of banks as supporting the real economy by lending to businesses that make and sell tangible products.” That comment captures very well an appropriate criticism of the “Western” approach to the financial system that has unfortunately not focused on the real economy but rather on making money from money and trading financial products without considering if those activities deliver any real value to society other than supporting high levels of bonuses for bankers.

Too often when mistakes are made at banks there are no consequences for senior management. This week Credit Suisse made it clear that consequences, even for senior managers, will occur when there are serious errors made that lead to losses. This is a hopeful change in the culture of banks that should only be encouraged.

For Credit Suisse it may be cold comfort for the shareholders but senior managers from both the commercial and risk management areas of the bank have paid the price for the cost of three recent incidents that call into question the ability of Credit Suisse to manage its risk positions. This story began to appear in public with issues related to Greensill Capital. On 11 March the Financial Times reported extensively on various issues related to this exposure including that headquarter based senior risk managers overruled risk managers in London regarding a loan to Greensill. The exposure for Credit Suisse turned out to not only be related to loans to Greensill but also to funds managed by Credit Suisse that had significant exposures to Greensill related debt instruments. The overall losses related to Greensill at Credit Suisse will probably never be fully known but they are likely to be in excess of $1 billion.

The second risk management issue arose relative to Luckin Coffee in China. As reported by Bloomberg, “’I’ve had I don’t know how many dinners with him in Beijing and he’s absolutely the poster child for what we want to do,’ Tidjane Thiam said at a conference last year when he was still head of the bank.” These dinners were part of an integrated strategy of Credit Suisse to provide both private banking and commercial banking services to wealthy individuals. As Thiam went on to say “He’s a dream client.” More likely a nightmare at this point as Luckin Coffee has collapsed due to an accounting scandal that has led to loan defaults.

But for Credit Suisse three times is not a charm but rather just more bad luck (or bad risk management). As reported by the Financial Times on 6 April, Credit Suisse is facing losses of $4.7 billion on its exposures to Archegos through its prime security lending and synthetic equity financing activities. For regulators and shareholders there is limited transparency on these activities so that large losses can surface unexpectedly.

But among this tale of woe there is a bright side. Again from the Financial Times of 6 April is a report that at least seven senior managers have lost their positions. Furthermore as reported: “The bank’s senior executives have had their bonuses for the year withdrawn, while outgoing chair Urs Rohner waived his SFr1.5m chair fee after facing criticism over his unchanged total pay of SFr4.7m for the year.” Clearly consequential actions but limited in comparison to the losses realised by Credit Suisse and the end of a share buy back program and a significant reduction in the dividend payment. But at least a step in the right direction of creating management accountability.