Banks sell risk. It became apparent that even they could not trade the risk they had on their books in 2008 and they faced bankruptcy. Governments bought it off them, with the exception of Lehman Brothers, which tanked. They do not want to, or perhaps could
not, do that again. Yet in the five years since Lehman Brothers, regulators have struggled to reform the financial world.
The big threat to retail and wholesale banking clients is that their banks might get caught up in losses from big bets gone bad. That has not been addressed. Even now trading firms report to me that banks, who will be banned from trading off their own books
from July 2014 under US rules, are taking proprietary positions via their algo desks, under the guise of dealing risk to their clients. That means they are exposing their own firms and the wider market to massive potential losses. Disguising proprietary trading
is a serious problem.
The ‘London Whale’ demonstrated how investment bank JP Morgan could be exposed to a US$6 billion loss via a risk management function. Two men are under charges of hiding losses on the bank’s books. Lehman Brothers had avoided showing losses on its books
by using a legal but, in the event, morally dubious accounting trick.
If firms are trading on a proprietary basis and hiding it from regulators, they are exposing their own firms - and thereby the banking industry - to risk. It is inevitable that even greater losses will arise than can be generated through a risk management
function, they will be hidden, and upon exposure they will bring down a bank.
Will the new Basel capital regime save a bank? In 2013 the European Commission issued a memo that noted “the quality and the level of the capital base, the availability of the capital base, liquidity management and the effectiveness of their internal and
corporate governance”, were what differed between banks that went bust in the crisis and those that did not.
Nevertheless there are discrepancies in the way that banks value their assets, according to the European Banking Authority, and that directly impacts their ability to calculate capital adequacy. Banks are also avoiding the issuance of new equity to reinforce
Tier One capital and instead are reducing their balance sheets to meet the leverage ratios under Basel. In doing so they are having to take more risk on assets that they hold in order to make better returns.
The impact on the high street of another big bankruptcy will again be enormous. Under the new recovery regime rules, holders of bank bonds and equity will suffer before taxpayers, but it is foolish to think that those losses are somehow insulated from the
rest of the world. Those assets will of course be held by businesses and individuals through investments. The man on the street always gets the bill.