Banks won't break their sweet addiction

Most banks are addicted to their gambling income, but every now and then someone blows up. This time it was JP Morgan, but don't bet on this to trigger a prop trading ban – not even the GFC could do that.

Australia’s banks make between $500 million and $1 billion a year each from trading, or what’s coyly known as "risk income”. But let’s call it what it is: gambling.

They know it’s kind of bad, but look, everyone else does it, you know, and it feels nice, so we need to do it as well.

All sporting codes impose a total ban on anyone involved in playing the game from betting; even small bets in the AFL, for example, are met with suspension and a stern press conference.

Bankers, meanwhile, are entirely free to bet on the games in which they are playing.

Last week JP Morgan revealed $2 billion in losses from proprietary trading in derivatives. Chairman and CEO Jamie Dimon then did a full Japanese-style mea culpa, but none of the banks, including JP Morgan, has shut down its prop trading desk and the regulators haven’t made them.

There are now new calls for more regulation to prevent the banks taking these sort of risks with government-guarantee money, but in my view the problem is not so much the occasional big loss but the fact that they usually make good profits from trading. For every winner there’s a loser, and every loser is a bank client; the banks, as a group, make their profits at the expense of their clients.

The Volcker Rule – a part of the Dodd-Frank laws in the US that are meant to regulate banking so there isn’t another financial crisis like 2008 – was originally going to outlaw proprietary trading, but the banks’ Washington lobbyists got to it and the version that is supposed to become law on July 21 is now 300 pages long and so complex that nobody seems to know what it does exactly. It doesn’t seem to ban prop trading any more, apparently.

Actually it’s so complex that the regulators won’t be ready for it by July 21 so it will have to be delayed.

The Glass-Steagall Act used to effectively ban prop trading by commercial banks because it separated them from investment banking, but that was repealed in 1999 after Alan Greenspan’s Federal Reserve board approved the merger of Citigroup and Travelers Insurance Group.

Paul Volcker was Greenspan’s predecessor at the Fed. He tried to undo one of Greenspan’s greatest mistakes, which he believed contributed to the GFC, if not led to it, but the bankers nobbled it.

Like Australia’s state governments, most banks are addicted to gambling income. They take deposits that are implicitly guaranteed by the state, and sometimes explicitly, and punt the money on a variety of financial instruments. Sometimes they are helping clients hedge their exposures; most of the time they are just punting.

Every now and then, someone blows up. Last week it was JP Morgan. Before that it was Societe Generale and Jerome Kerviel, and later Kweku Adoboli at UBS. And way before that Nick Leeson at Barings in 1995 and of course the Luke Duffy four at NAB in Australia in 2003.

Compared to what has been made by global banks from prop trading over the years, the total losses of these rogue traders are peanuts.

Bankers continue to boost their profits through gambling because they can. Why don’t they lose more often, like most gamblers? Because they know more than anyone else about what’s happening at the track.

Of course it’s not as blatant as a tennis player betting on a match then throwing it. It’s all about knowledge of the markets and depth of research, which banks are paid by clients to possess.

They disclose their gambling exposures through what’s known as Value at Risk, or VaR, which was invented, in fact, by JP Morgan. Before its big loss of last week, JP Morgan’s VaR was $127 million, recently bumped up from $67 million. So much for VaR.

A lot of people are now saying that JP Morgan’s loss will give ammunition to those who have been arguing that VaR is insufficient disclosure and to the regulators trying to ban prop trading.

Don’t bet on it.

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