Four Questions about the Effects of Trading on Financial Institutions

Nov. 08, 2011 11:22 AM ETBAC, C, GS, JPM, MS, WFC
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Contributor Since 2010

An international economist with 40 years experience in multinational financial services organizations, Kurt Kendis has worked as a strategist, analyst, and consultant for boards, senior managers, and executives worldwide. With a background in academia, he is currently Managing Director at The Banking Group. His subject matter expertise is global strategic management, restructuring, multinational risk, board development, and capacity building in emerging markets’ banks.
Although I read my share of research and analysis, I have yet to find full answers to four basic questions:
Exactly how much of trading volumes is driven by high speed trading, ‘pure’ speculation, and ‘wrap’ products that are added to other transactions by financial institutions for speculative purposes?
I have seen sector specific analysis, and a lot of press, about very high percentages in commodity or currency transaction volumes. Are these research results comparable for all markets? If they are then I am curious about the impact of increasing or declining recognized revenues for F.I.s each quarter, and of course the pressure to augment volumes to meet revenue goals.
How much influence on the levels of volatility and general price levels can be attributed to trading as a purposeful activity (not as investment activity)? There has been a lot of theoretical work about how sophisticated products and positions prefer higher price levels to allow wider spreads and hence profit opportunities. Is there evidence that the community of trading transactors push price levels higher deliberately? There has been some spot work on oil, but not much else.
Are high volatility and high pricing at all attributable to the ‘herd mentality’ as speculators pile on to a name? The press hints at how certain commodities or risk spreads for certain countries might actually be susceptible to ‘attack’ by groups of speculators, not necessarily organized, and hence highly volatile. This generates a valuation issues for F.I.’s when markets deteriorate. (Is there such a thing as a ‘bear raid’?...and is it material)
The financial guarantees intertwined with many of these trading products are still off balance sheet, particularly in Europe. When or if the underlying positions deteriorate, is there systemic risk?
Reviewing recent analysis of Erste Bank Group reveals a lot of opacity on the guarantee business for financial trading products in all financial institutions. Now (in Jeffries) we also see that the exposures are listed in the VIE’s.  In the extreme, this is A.I.G. redux.
Can these potential impacts be connected to a materially higher cost of capital for financial institutions? If there is real evidence of the effects of market transactional activity on F.I. revenues, risks, and valuation; there is a concern for the cost of capital for the F.I.’s disproportionally involved in these activities. Not only is there internal hurdle rate much higher , leading to more risk taking, but we might also see a real elevation in the cost of raising tangible Tier 1 equity.
What was the tag line in the sixties “Inquiring minds want to know?”

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