In July I published an article on S.A. called "The Traders Did IT!" In that article, I blamed traders taking over the banking business for many of the ills that the business has experienced over the last decade.
Gillian Tett's excellent commentary in the November 1 FT on Union Bank of Switzerland (UBS) exiting at least parts of the investment banking business reminded me that there is more to say on the subject. As Ms. Tett pointed out,
"[The} half-formed Basel, Dodd-Frank and Volcker rules are starting to bite: when UBS announced its cuts, it said the new regime made it uneconomic to run a fixed-income operation. Deleveraging is under way too. So it should be no surprise that UBS now wishes to focus on simpler, more transparent transactions that serve the retail base."
Lest anyone think that a large fixed income trading operation and high leverage are required for successful banking, one need only look at a little bit of history.
The Glass-Steagall Act
Trading in securities was practically unknown in American commercial banking until the 1980s. The Glass-Steagall Act gives a sense of how small a factor it must have been in the 1920s and 1930s. Of the four sections that comprise the Glass-Steagall Act (Sections 16, 20, 21 and 32 of the Banking Act of 1933), none deals specifically with trading in securities. The closest that any section comes is Section 16, which was codified as Paragraph Seventh of Section 24 of USC Title 12, a part of the National Bank Act. That paragraph restricted national banks (and through another section of the Act, all Federal Reserve Member Banks) from dealing in or even owning securities other than "investment securities," which came to mean debt securities that were rated investment grade. But there is no mention of or prohibition against trading such securities. The pertinent provision reads:
The business of dealing in securities and stock by the association shall be limited to purchasing and selling such securities and stock without recourse, solely upon the order, and for the account of, customers, and in no case for its own account, and the association shall not underwrite any issue of securities or stock; Provided, That the association may purchase for its own account investment securities [later defined as only debt securities] under such limitations and restrictions as the Comptroller of the Currency may by regulation prescribe.
Under the Securities Exchange Act of 1934, the term "dealing in securities" did include trading as a business, and one may presume that it had the same meaning in the quoted provision of Glass-Steagall, although it was enacted a year later and there are occasions when a term has different meanings in different statutes.
But that trading was not a major target of the Glass-Steagall Act is a reasonable inference from the other three provisions that deal with various aspects of the prohibition against commercial banks engaging in underwriting securities but do not mention dealing or trading. Underwriting securities was the great bugaboo because it was thought, variously, that the banks' underwriting arms had foisted bad securities on the public in order to bail out their commercial banking operations or that banks had speculated in securities as part of their underwriting operations.
There never was much evidence to support the charges made against banks underwriting securities, but as happens after all financial crises, Congress has to do something.
I have read just about every document and debate in the legislative history of Glass-Steagall, and I do not remember any discussion of trading in securities; speculating yes, trading no. I admit that I read the history in 1969 and that my memory of hundreds of pages at 40 years remove is not perfect, but I think it would have made an impression on me, since my Glass-Steagall research was the focus of my first important independent legal work.
Trading Comes to the Fore
It is not surprising that the framers of Glass-Steagall did not discuss trading because trading as a business was not a major part of the securities markets until the late 1970s. The securities business of the 1950s to early 1970s was dominated by separate silos of firms in the retail brokerage and underwriting businesses and the specialists on the New York Stock Exchange. The national retail brokerages, often called wire houses, such as Merrill Lynch, Bache, E.F. Hutton and Smith Barney, all based in New York, and regional firms like Sutro Brothers in San Francisco, Piper Jaffray in Minneapolis and Butcher Sherrard in Philadelphia, all of which participated in underwriting syndicates to sell new issues to their customers but none of which either made trading a major part of their business or were to be found among the lead underwriters on major deals. The great underwriting houses included White Weld, Kuhn Loeb, Lehman Brothers, First Boston and Goldman Sachs, none of which maintained a large retail brokerage operation and few of which had trading operations of any size. Market making in specified securities was done both by the underwriters and by the brokers. Trading in NYSE-listed stocks was dominated by the specialist firms that had a practical monopoly on the deal and information flows. Almost no major corporations traded off the NYSE.
Commercial banks were nowhere to be seen in this landscape. They lent money to the brokerage firms but they did not compete with them.
The landscape began to change when the U.S. went off gold convertibility in 1971. When Franklin National Bank failed in 1974, then the largest bank failure in American history, the FDIC found that Franklin had a "foreign exchange book." That is, Franklin had been trading in foreign exchange. No one at the FDIC knew anything about foreign exchange. Bob Barnett, the FDIC Chairman's deputy and I, his outside counsel, had to go to the Federal Reserve Bank of New York where the couple of experts in the field tutored us in the confusing world of foreign exchange, with its foreign terminology of "vostros" and "nostros."
But in the 1970s the landscape at the investment banks changed faster than at the commercial banks. Major investment banks like Lehman Brothers and Salomon Brothers were taken over by their traders. The traders made more money than the underwriters and merger and acquisition specialists, so they came to dominate-and later to destroy-those firms. Some of the investment bankers hooked up with foreign banks to give them the capital strength and size to engage in trading operations. First Boston hooked up with Credit Suisse and Drexel Burnham hooked up with French bank Paribas, for example. In 1985 Bear Stearns, which had been a major trading house for a long time, was the first brokerage firm to go public for the purpose of bulking up its trading operations. The other major investment banks and brokerages followed suit or merged to gain bulk, with only Goldman holding out until 1999.
The major New York commercial bankers had looked on the underwriters with envy for years. Now they began to covet the trading business as well. And whereas Glass-Steagall was clearly aimed at underwriting, it was not so clearly aimed at trading.
Morgan Guaranty Trust Company, the banking half of the Morgan empire that had been split after Glass-Steagall, was the first commercial bank to move into trading in a big way. JP Morgan and its capable lawyers fashioned a series of exceptions to Glass-Steagall that the Federal Reserve agreed to. Other banks followed Morgan's lead.
Technology also played a major role in increasing commercial banks' trading business. Like foreign exchange, derivatives, were not securities. They therefore did not fall within the parameters of Glass-Steagall or other provisions of state and federal law that restricted banks' securities business. Interest rate swaps of all kinds were fair game, for example, as long as the banks could convince the regulators that they were safe enough.
The large trading book changed the banks' needs for size. Whereas the biggest banks of the 1970s, First National City Bank (now Citibank), Chase (now JP Morgan Chase) and Bank of America, had global scope, they were small by later standards. All the large banks bulked up, by merger and otherwise, to take advantage of the latest trading strategies as they opened up. And the higher the leverage a bank could manage, the higher its return on equity and the higher the executives' bonuses. This process continued throughout the 1980s, 1990s and the first half of the 2000s.
UBS Exits the Trading Business
Let us return now to Gillian Tett's observations about UBS: "Basel, Dodd-Frank and Volcker rules are starting to bite: when UBS announced its cuts, it said the new regime made it uneconomic to run a fixed-income operation. Deleveraging is under way too," she says.
What is going on here is that the large banks throughout the world used their ability to highly leverage their capital and to raise cheap money to gain competitive advantages in the trading world, particularly in trading derivatives and other esoteric products. Basel 3 has made that game more expensive. The Volcker Rule is going to make proprietary trading much more difficult to sustain, even with some regulatory capture to gain flexibility around the edges.
But I think something else is happening as well: Trading-in any financial instrument-is a zero-sum game. Whereas investing makes money for the investor class as a whole, trading can make money either only for the best traders-the others will lose money-or the traders have to be making money off non-trader pigeons. I think the non-trader pigeons are starting to catch on. Therefore traders have to beat each other in order to make money. And that is much harder to do. A bank like UBS might rationally decide that the game has changed. It has a strong franchise in serving the wealthy, for which it is paid quite well. The risks involved in competing with the best trading banks and the best hedge funds may not be worth the candle. The UBS wealth business is steady and stable, and it will gain a higher p.e. for the UBS stock than trading profits and losses.
Bear Stearns and Lehman Brothers lived by the trading sword and died by it. Some think Goldman and Morgan Stanley could have gone the same way had they not been rescued by becoming commercial banks. Merrill Lynch almost died because of its trading book. Those lessons are not lost on smart bankers.
The Bloom Is Off the Rose
My guess is that the bloom is off the trading rose. The banks feasted on the pigeons that tried to play in the game, such as municipalities convinced to hedge their interest rate risks. With the pigeons gone, those that are fighting the Volcker Rule are the few that think they can outsmart everyone else or that they still can find pigeons. I am starting to think they are wrong and that the London Whale incident at JPMorgan is a symptom of that change rather than merely a blip in JPMorgan's risk management system.
The trading business belongs in the hedge funds. They cannot raise money as cheaply as too-big-to-fail banks, but they can take risks without regulators breathing down their necks, and they can specialize. And when hedge funds fail, no one but the banks that lent to them and their investors care very much. That is as it should be.
Banking Will Be a More Stable Business
For we individual investors, what does this mean? I think it means that banks like JPMorgan (JPM), Goldman, (GS) Morgan Stanley (MS) and Barclay's (BCS)that have thrived on the trading business in the 1990s and 2000s will not do so in the future. They will have to rely on more traditional forms of banking business, including new ways to serve their clients that the electronically connected world has made possible. How they will adjust their business plans and their personnel to these realities remains to be seen. I think they are in the process of adjusting, even if, like JP Morgan, they are leading the rear-guard action to protect their trading business.
The traders took over the great commercial banking and investment banking houses beginning in the late 1970s. They participated in the burgeoning of the financial sector and the proliferation of debt that led to the Great Recession. Most of them made a ton of money, using other people's money and the government backstop to do so. They were smart to do so. But at the large banks, I think their day is done. That is good. Society never should have subsidized their business in the first place.
Banks like UBS and Wells Fargo (WFC) that stick to what they do well should flourish. Some banks will make money in trading, but the market is not likely to accord that income a high multiple.
Disclosure: I am long GS.