On the indispensability of (investment) banks

As might be expected, there’s a fair amount of questioning about the finance system as a whole going on.

The claim is that the market is best able to distribute this cash to the most worthy of projects, but at what point is their judgement questioned? How are these bastards allowed to be indispensable?

It’s true that the purpose of the finance industry is to, as efficiently as possible, allocate capital (i.e. savings), risk and returns; or, as the Economist puts it, to write, to “write, manage and trade claims on future cashflows for the rest of the economy.” In that regard, the industry as a whole plays a vital role in the economy. But that on its own doesn’t necessitate the indispensability of individual banks. That comes from a variety of inter-related factors:

  • There are banks and there are banks. Ceteris paribus, nobody cares if a Small-Town Bank (STB) goes bust because it is provincial: nobody other than its direct debtors and creditors are affected. Investment banks are (effectively, sort of) where the STB goes to borrow money, though. If they go down, so do all the little commercial banks that depend on them. To use a cheap analogy from The Wheel of Time series of fantasy novels, one might think of the central bank as the True Source, the investment banks as Rand al’Thor using one of those artefacts and all the little banks as power-wielders that are vastly powerful compared to civilians but insects next to Rand. Rand channels the hundreds of little power-wielders and adds his own enormous ability to suck down the juice in order to draw massively on the true source. If somebody were to kick Rand in his privates while he’s doing his thing, half the planet gets ripped asunder. Therefore, the protection of Rand while he’s doing his thing is paramount. He is genuinely indispensable. This analogy neatly explains why you don’t actually want a single investment bank, btw. Having a single, semi-god-like character that’s able to channel the über-load of the True Source is great in a novel, but bloody stupid in real life. Redundancy is key. You want several investment banks that are competing with each other so that if one goes belly-up, the others can take over.
  • Real innovation is rare, so when somebody has an idea, all the banks leap on it at once. That’s nominally fine in itself, but it unfortunately means that the actions of the (investment) banks are highly correlated, which makes for fantastic profits when it all works and a world of pain when it doesn’t. In essence, even though they’re are several investment banks competing with each other, since they all offer the same services at the same prices using the same strategies, they’re acting as though they’re a single investment bank.
  • The latest round of innovations has served to tie a lot of financial institutions together from the perspective of policy makers. This point really comes in two parts:
    • Securitisation and the splitting of those securities into tranches of risk exposure, in principle, allow financial institutions to spread and share individual risk between themselves so that if a Bad Event happens, they all lose a little rather than just one of them losing a lot.
    • There has been a general move away from transparency, with most of these securities being held off balance sheets and being traded in private sales instead of on open markets.

    The securitisation and tranching may have gone too far over the last few years, but that on its own isn’t the problem. The problem is that it was combined with a lack of transparency, meaning that it has become enormously difficult to pick apart the pieces when somebody falls.  To quote the Economist again, “Bear Stearns may not have been too big to fail, but it was too entangled.”  While they could have let Bear Stearns fall rather than be swallowed by JP Morgan, doing so would have required the careful unpicking of all of Bear Stearn’s positions, which would have taken months.  That would then have fed into the final point …

  • People are nervous lemmings. Even if the investment banks were properly competitive and transparent and each employed different strategies so that if one fell, there wasn’t so much risk of the others falling, a major bank collapse is still a problem because we’re all idiots. We panic. Then we see each other panicking, which helps us justify our own panicking and makes us wonder if maybe we’re not panicking enough.  The panic can then develop a momentum of its own, causing other banks to collapse when they otherwise didn’t need to.

So … that’s why they’re indispensable. But that doesn’t mean that we should be paying them the way we do.  Judgement of bankers’ performance is really only measurable after we pay them, which is stupid.  I’ve written briefly on bankers’ pay before here.  It is worth noting, though, that calls for bankers’ pay to be made in the form of stock have to face up to the fact that many employees of Bear Stearns had a huge share of their savings invested in Bear Stearns stock.

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