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Friday, September 16, 2011

Too big to fail … and too big to manage!

Yet another rogue trader scandal. From the blog interfluidity:  (Steve Randy Waldmann)

The financial scandal du jour is a $2 billion dollar loss at UBS blamed on a “rogue trader”. You’d think the whole “rogue trader” problem would have been solved by giant, sophisticated investment banks. After all, it was way back in 1995 that Nick Leeson brought down a 233 year-old global institution. Since then we’ve had John Rusnak at my hometown bank, Jérôme Kerviel at Société Générale, and others.

Kid Dynamite, a former trader himself, notes that “losing $2B without anyone knowing about it is much harder than you think“. To generate a $2 billion dollar loss in a short period, a trading position has to be gargantuan. Some dude on a trading desk can’t just put on that kind of trade.

Calling them rogue traders is a sham. As Matthew Yglesias writes:

These rogue traders are out there because their bosses don’t want to know what they’re doing. I never get a “rogue burrito” at Chipotle because the management wants people to get burritos that are rolled properly. But suppose the management wants people to obtain the kind of high returns that can only be achieved through unduly risky trades. Well, you can’t very well issue a directive telling people to make unduly risky trades. You certainly can, however, create circumstances under which incentives, control, and supervision are structured so as to make it the case that “rogue traders” will pop up here and there and then there rogueishness can be blamed ex post for undertakings that go badly.

This is, in part, because when the risk pays off it pays off handsomely for the trader and their managers up the line. If it fails, nobody gets executed. In fact, if you look at the “rogue traders” in the second paragraph above, I would doubt you would find any of their managers in prison, homeless, or even living in a lower middle class suburb. No, you just get another position.

The repeated “rogue traders” are an indication that large institutions are able to get the government to protect them from going down (too big to fail) and are also poorly managed despite the last five years of gargantuan failure (too big to manage).

In my opinion, they will remain too big to manage effectively so long as they are too big to fail.

I’ve been very disappointed in the Obama administration (and, for that matter, the European governments) for their failure to address this problem. 

With smaller banks, we might see more of this type of personality managing money (Yglesias again):

I was always struck in college, watching people head off into the field of finance, by the mismatch between the demographics of the folks who’d go be bankers and the stated desire to manage risk. If I’m conjuring up in my head a vision of a prudent risk manager, I’m thinking maybe a mother of two. Someone smart, of course, but also someone who’s cautious. Someone who sees the whole field. Someone who juggles. I’m not thinking “young smart arrogant dude with limited practical experience and a burning desire to get ahead.” That to me sounds more like a rogue trader!

I’d want to know: were those children planned?