Putting all the recent -- and several not-so-recent -- financial scandals together, it becomes clear that in a great many cases traders in high places have been responsible. My conclusion is that the trader mentality is incompatible with the management of banks and bank-like financial companies.
I recognize that this is a broad and damning allegation about a large class of people. And, of course, there must be exceptions. But please look at the list of culprits before you conclude that my broad-brush condemnation cannot be true.
Beginning with the most recent, we have Peregrine, the commodities broker that went belly-up this week with over $200 million of customer funds missing. Peregrine looks suspiciously like MF Global, which went the same route about half a year ago, with billions as opposed to hundreds of millions of customer funds missing. It was run by a trader. Think about Barclays, the fraud poster child of the last month. Barclays just happened to have been run by Robert Diamond, a trader. Think about the supervisory traders at JPMorgan's (JPM) CIO in London who supposedly had "the London whale" under control.
Now let's go back to Bear Stearns and Lehman Brothers. Both just happened to be run by traders (James Cayne and Ken Fuld, respectively). Who was at the helm of Salomon Brothers when Buffett had to bail it out? Traders (see Liar's Poker). Who ran Long-Term Capital Management? Traders, natch -- though they appear to have been honest. Bernie Madoff also just happened to be a trader. The business of Enron just happened to be trading, mostly in gas but also in electricity, broadband, and maybe other such esoterica. What brought Barings down? A trader. What almost brought UBS and Societe Generale down? Traders. Need I ask whether you remember what Michael Milken did or what he went to jail for? (I understand that he has rehabilitated himself, but in those days he controlled the trading market in high-yield bonds.) It doesn't seem to matter whether the traders are in London, Paris, New York, New Jersey, Greenwich, Conn., Iowa, or Singapore.
Who has been going to jail for insider trading in recent months? Traders. We are beginning to see a pattern here, no?
There is logic to the appearance of wrongdoing. Traders are trained to react quickly and take advantage of very small informational advantages with large sums of highly leveraged money. They usually are asked "How much?" Not "How?" "How," they sometimes may claim, is a secret.
Trading Does Not Belong in Banks
The implications of my charge against the trading fraternity are significant because they include separating trading from banking. If traders are as prone to shenanigans as the examples cited above suggest, then traders have no place in a banking institution. They may play a role that is useful to society in some ways, but that role is incompatible not only with commercial banking, but also with corporate finance. Both commercial banking and corporate finance depend on the public's trust. Trading requires no public trust -- and it has none. Therefore, the Volcker Rule has to go further; it has to abolish trading in banks. Public policy should push trading into non-banking companies. Let the CFTC and the SEC regulate the traders, which they will do badly because of regulatory capture. Customers beware!
But at least the traders will not infect legitimate commercial banking and corporate finance as they have been doing since the 1980s, when trading first infected the investment banks and some of the large commercial banks. I used to think JPMorgan could be a trading bank because it was better managed and had better controls. I think so no longer, although it may have been true in the 1990s.
The U.K. and France, at least, will be willing to bar trading from banks if the U.S. does so, and I believe the Swiss will follow with alacrity as will Germany, with an EU-wide rule soon to follow. The competitive issue thereby will be overcome.
Who will do derivatives trades for businesses that need to hedge? Specialists will do the trades. If the specialists are not large enough to be trusted, then banks and insurance companies can do their proper jobs by guaranteeing or otherwise supporting the credit of the specialists, if they are creditworthy.
Bring On the Tobin Tax
But the implications go further: Sand should be thrown in the wheels of the traders. A Tobin tax of a very small amount should be assessed on every trade of less than a specified duration. It should not be designed to make money. It should be designed to make short-term trading an uneconomic activity.
Europe and America could be ready to adopt such taxes, which should be uniform and should cover all transactions done with any connection whatsoever to either the U.S. or Europe. Will the traders go to Asia or Dubai to trade off the large exchanges? Perhaps. But they would then have no investors to prey on, which would be beneficial to the U.S. and European stock and bond markets.
Trading and Its Accompanying Leverage Are Harmful
The biggest change in the financial markets since 1970 has been the advent, then ascendancy, of trading. I am not a fan of nostalgia for "The Great Financial Time" of the 1970s or 1960s. I think that is a lot of hooey. But when I look at the many financial scandals and failures over the last 40 years, I am struck by how many of them have been caused by trading and, not incidentally, by the extreme leverage that often accompanies trading.
A few months ago I suggested that JPMorgan was a good long-term investment. I have sold my position. I now would not buy any bank that had a major trading position. If you want to invest in a major U.S. bank, try Wells Fargo (WFC). It has a smaller trading footprint.
I also am recommending a book today: The New Depression, by Richard Duncan. It is indeed pretty depressing. But it is well written and makes a compelling case for stagnation at best over the next several years. It also details why investors might well steer clear of banks with large derivatives portfolios.