S&P 500 2,003.37 0.00
Gold$1,288.00 $0.30
Nasdaq 4,580.27 0.00
Crude Oil $66,890.00      $-40.00

Six Myths - Bigger is Better in Banks

Author: Devan Biswas
Last Update: 1:36 PM ET May 18 2012

1:30 PM New York – For decades banks have argued in favor of expansion in the belief that bigger means better. History of banks suggest more risk taking is not always rewarded with larger gains and lawmakers should separate not curtail risk taking from depository institutions to prevent the next collapse.

Large banks and financial companies have a way to surprise investors with mega losses that have become far too frequent.

Though markets are focused on the latest loss of at least $3 billion at JP Morgan Chase & Co but similar losses have occurred frequently in the industry. In the last four years alone the list is long.

One has to only look at the loss of $2.3 billion at the London office of UBS, billions of dollar missing at MF Global. Subprime loan losses of $9 billion at Morgan Stanley, losses at Fannie and Freddie and Citigroup near collapse of Goldman Sachs and the demise of the AIG, Lehman Brothers and Bear Stearns.

And prior to 2008 and 2009, the total collapse of LTCM in the late nineties, bankruptcy of several names at the Lloyds of London and the total demise of Japanese banking system in the late eighties was not that distant.

But, one thing has been common across recent well known large financial losses, bigger the banks get bigger the risks get and larger the losses borne by taxpayers.

Like every teenager, banks are always looking for ways to take on more risks and believe that they are smarter than the market and can handle more risks than they are allowed to take. The desire to take on more risk is primal and the hunger to take more complex risks than one can handle is just as inherent to the industry.

For decades, U.S. banks had argued to the Fed that they need to merge and be allowed to expand into other risky businesses, especially in the eighties when Japanese banks dominated the global landscape, recalled Paul Volcker at a recent testimony in front of the U.S. Senate committee.

Banks argued to regulators and lawmakers that they cannot compete globally unless they are allowed to expand into proprietary trading, investment banking and permitted the presence in all fifty states.

The other argument that was put forward and advocated by the former Fed Chairman Alan Greenspan was that in the final analysis a bank will never take on the behavior that will endanger its existence.

Greenspan was so convinced in the logic that he argued on behalf of banks for virtually no rules for banks in the name of free markets in his public speeches and in private conversations with lawmakers.

On the contrary, banks have shown frequent tendencies and behavior patterns that are self destructive. The history is replete with casualties dating back centuries and JP Morgan offers just the latest example.

While the media is focused on the size of the loss at the bank but the real question is how much JP Morgan’s capital was put at risks and how much of it was disclosed to regulators. While the loss in the trading represents only 1.2% of total $369 billion managed by the investment office at the bank but the complexity of the trades can quickly morph and the amount of losses can escalate in days before they can be unwound.

There is no way to eliminate risks entirely and who decides when does risk taking gets in the way of public interest especially when depositors are involved.

In the world of finance, risks come in so many forms and the nature of risks is constantly changing. While we can mange or control rick but we can never eliminate it entirely. In the end, risk yields unpredictable results.

Investors long have relied on statistical techniques to manage or minimize the risk that is known and or quantifiable, but risks are always morphing faster than they can be modeled.

Over the years, experience has taught investors what we cannot afford to lose is the biggest risk of all risks and often times we are not aware of how much we stand to lose and how quickly that can happen.

Banks are fighting vigorously the new reforms that are likely to curtail their ability to take trading risks. Ironically these reforms are designed for the self preservation of banks, but most management do not see it that way, especially more than half of revenues are given out as the bonuses at the end of each year.

Banks with the connivance of lawmakers have successfully watered down the line between hedging the risks on balance sheet and trading for gains with no collateral.

The biggest risk that most large banks have is that in most derivative products they sell or trade, they are the market and in the end they are the largest repository of the risk. In fact, the intense industry lobbying has managed to deflect the regulation from banning all risks in the name of hedging to vague explanation of what is appropriate risk.
  1  2
Sources: Data collected by 123jump.com and Ticker.com from company press releases, filings and corporate websites. Market data: BATS Exchange. Inc