A V Rajwade: Risk and reward

Financial firms got the rewards, we paid for the risks.

There were two interesting headlines on a single page of the Financial Times (February 5, 2009) recently, which clearly witnesses the dichotomy in the risk- reward relationship between financial markets and the real economy:

 

 

 

“Special FX: The asset class that thrives on volatility — foreign exchange desks at the major investment banks have been enjoying record years”. 
 

“US company earnings hit by turbulence in currency markets”

Often, large profits can be made in financial markets without the need for any great talent or analysis. A report in the London Times (January 23, 2009) suggests, for example, that Société Générale (SocGen), the French Bank, had the best trading day in its history on September 11, 2001, the day of the terrorist attacks in New York and Washington. Obviously, on that day, it did not require a genius to short the stock markets, particularly the insurance and airlines sectors, to make money. All that you needed was capital which, of course, SocGen had. Jerome Kerviel, the trader who lost SocGen $7 billion in early 2007, also had a great day on July 7, 2005, the date of the London bombings. The report does not indicate how much bonus Kerviel earned on those two days. While hedge funds are far more secretive, surely they also made huge profits on these days.

Such profits have created the huge asymmetry in the compensation levels in the financial and real economies: How long can society continue to reward dealmakers and speculators far more than those who work hard, are enterprising, innovate and add directly to the employment and output in the real economy, the welfare of society as a whole?

It is often argued that speculation, namely trying to profit from changes in price movements, is a zero-sum game, that somebody’s profit has to be somebody else’s loss. This is true, of course, but clearly not for the financial economy by itself: Practically every bank has reported trading profits year after year. 2008 was an exception with huge losses in the trading book, thanks primarily to the excesses of the financial system itself. But these losses are being borne in spades by the society at large, and not so much the bankers.

There is another myth about the functioning of financial markets: They are supposed to be self-correcting. Once again, very true but only in the long run. In the interim, given the herd instinct and the popularity of trend following, the mis-pricing of assets can be egregious, and is rationalised by “retrospective determinism” (Nassim Taleb’s expression). Apart from his famous comment on the long run, Keynes also had something to say about mis-pricing: Markets can remain irrational far longer than the player can remain solvent. George Soros has coined an expression to describe how markets function: “Reflexivity”. His argument is that fundamentals affect expectations which in turn affect prices — but the changing prices themselves affect expectations in a merry-go-round, “until the music stops”. As early as 1910, Keynes had pointed to the part played by ‘expectations, ignorance and uncertainty (all left out of the …models of much conventional ... theory)’ in the decisions to invest, all so dramatically illustrated in the losses sustained by supposedly sophisticated banks in credit derivatives.

Top bankers got hauled up for questioning about the recent credit crisis before both the US Congress and the British Parliament in recent weeks. As Christopher Caldwell wrote in the Financial Times (February 14, 2009), “The problem … was not that they were malevolent but that they were mediocre”. If this is the reality, the problem is that too many people believe in the honesty and wisdom of bankers, that proximity to money itself gives special knowledge. This faith in the wisdom of bankers has come out once again in another case in the United States involving Sir Allen Stanford, the Texan billionaire and famous cricket promoter, whose bank has defrauded depositors of at least $8 billion of their savings. Sir Allen’s bank was paying as much as twice the going CD rate which is what attracted the innocent, if greedy, depositors. Coming on top of the Madoff scandal, the fraud does little to improve the reputation of US regulators. The two cases have several things in common: External analysts had been suspicious of the returns for years; the firms were dominated by individual personalities; and had inconspicuous auditing firms (not that PWC and E&Y have done better in Satyam). Perhaps Nassim Taleb diagnosed the situation correctly: “Humans will believe anything you say provided you do not exhibit the smallest shadow of diffidence; ... The trick is to be as smooth as possible in personal manners.” Clearly, Sir Allen and Madoff were.

avrajwade@gmail.com