MAXING OUT

With more gloomy data and markets in freefall, it is time to take stock and maybe put that credit card away.

I am a big fan of the Arthurian legends and have read various interpretations over the years. However, there is always that time when the proud King is going to be betrayed and he is going to go into his last battle and although you know that it is going to happen, there is nothing you, the reader, can do to stop it from happening.

The global economy appears like this at the moment. Like the slow-motion of a car crash, we can only look on in horror as the world approaches the buffers.

David Cameron made a telling point to the Canadian parliament this week when he pointed out that this is not an ordinary cyclical recession. Too right it’s not, mainly because we never really left the last one. Since 2008 we have been limping along, hoping that our numbers come up and we can head to the uplands.

Despite the self-congratulations of policy makers two years ago, we are back where we started where the money markets are beginning to shut themselves down to banks with heavy sovereign debt burdens, global growth is stagnating and even China seems to have reached its peak in terms of economic activity.

We are, in the words of the World Bank’s chief Robert Zoellick, in the danger zone.

But what are we going to do?

Cameron told the Canadian parliament that “it’s a debt crisis”. And debt is a problem.

In Canada, the politicians hit the debt problem during the boom times and so led to the state of the nation today where they have a more than ample war chest to offset the hazards that are on the horizon.

Essentially, Canada paid off its credit card and stuck it in a drawer and has vowed not to take it out unless absolutely necessary.

In Greece, the debate is whether to borrow even more money to service the credit card whilst being given a diet of broth and hard labour or to declare bankruptcy and start again with creditors impatiently waiting for it to earn enough money to begin to pay back its debt – if it pays it back at all.

Here in the UK we are in a half-way house where although we know that we should be paying back the debt but our family keeps demanding new shoes so we pay a little back, spend a little more and hope to inherit some money.

America? Well, America appears to be magicking up new credit cards whenever it hits its limit.

Let me make it clear to you – if you run up a credit card, max it to the hilt, do you keep spending and to hang with the repayments bill or do you cut back on your spending and try and clear the debt?

Many complain that we must spend our way out of recession but if we just keep driving up that credit card, eventually, like some European banks are finding out, the credit will stop and where will we be then?

Now, there is a risk that we will be forced into some speculative spending. But instead of some Roosevelt public spending plan, why not a tax cut? If we are going to have to use that credit card again to stimulate the economy, put that stimulus into the producers. Yes there is a risk that people will just hoard the bonus but that is what the banks did with the bailouts and at least the money will be with the private individual rather than a further expansion of the state.

On an aside, I quite liked the idea of instead of bailing out the banks, we should have just given each taxpayer £300,000 to put towards a house. Mad, but amusing and possibly effective at the same time.

At least for the moment, we in the UK are not getting more credit cards. Quantative easing (QE) is only effective in a short spell. The QE program that the Americans embarked on has had zero effect on its economic problems and may indeed have exacerbated them with doses of inflation and unemployment.

To me, the idea of QE being an effective way of managing your way out of debt is about as useful as giving a drunk a shot of whisky so they can make it to the next pub.

There is a further problem to contend with in our current situation. Uncertainty.

The markets are marking themselves to the situation at hand which is one of sheer uncertainty. We are unsure of what the eurozone is actually going to do next. With briefings and counter-briefings flying all over the place, the markets reflect this, hence the volatility.

Whichever decisions the eurozone makes, it will have to be clear and unambiguous. Whichever way they go, the markets will act in the appropriate manner but at the moment the markets are just unsure about whether Germany is going to take away Greece’s credit card or pay it off.

SWISS HOLES IN AN INVESTMENT CULTURE

With the bank’s reputations under attack again following the revelations that rogue trader Kweku Adoboli had lost UBS $2.3bn (£1.5bn) in unauthorised trading, it will no doubt increase calls for the splitting of banks’ functions. However, once again, behaviour appears to be at the root of the loss.

Coming as it did after the Vickers Report which recommended the ring-fencing of retail banks from the investment side; the news was a fillip for critics such as Coalition business secretary Vince Cable.

However, this is not a reason for taking an even harder line with banks and there is a risk that the bigger picture – what is good for the UK? – will be lost in the catcalls that will no doubt get louder after these events.

As I have pointed out previously, a lot of what has happened in finance over the past few years, or indeed forever, has been behavioural. Judgment calls have been wrong, or banks have been too eager to lend or politicians have been too eager to tax without working out what the effects will be.

And it appears that there is a behaviour issue here coupled with poor corporate governance.

Most traders nowadays are surrounded by risk and compliance managers. They are checked at least once an hour; some are checked every twenty minutes, to keep an eye on what their positions are. In addition, traders are given ceilings with which to trade, a ceiling that will allow for an “acceptable” loss during a day’s trading.

Yet this appears to have gone wrong for UBS. Where were their risk managers? Where was compliance? How did Adoboli manage to rack up $2bn in losses?

UBS had a reputation for stolid, conservative banking before it has to be bailed out by the Swiss authorities in 2008. In total, the bank lost around $50bn in the financial crisis and the chief executive Oswald Gruebel has worked hard in restoring its reputation.

However, it may be that its conservatism was the issue.

Unlike their “Anglo-Saxon” counterparts in the US and UK, the Swiss – and for that matter the German – banks were not known as having risk cultures. Steady and sure. So when they got into the investment market boom after deregulation, could it be that they were ambushed by the risk culture? Did their behaviour cause them to not recognise where the risk issues were? Or maybe, they were swept up in the investment frenzy that was going on? Certainly, judging by their debt exposures, they certainly took on positions which most UK banks would baulk at without better hedging.

So how could $2bn disappear without being noticed? Well, the good money’s on this being in the so-called exotic markets of options and derivatives and was probably traded through an exchange-traded fund. These are not highly regulated and in the vast majority are not regulated at all as most are considered as private rather than public deals, coming as they do between two parties.

The fact that UBS allowed $2bn to be placed, probably in a series of trades, shows a disregard, or perhaps even an ignorance, of risk. Indeed, this morning there are reports that it was Adoboli who informed the bank of his losses. This appears to be a fundamental flaw in its internal control systems and seems to show that UBS has some serious governance issues.

How do you regulate against behaviour? You can’t. You can inform, educate and train but as has been seen with the outgoing Financial Services Authority, tick-boxing is no guarantee against behavioural risk, or fraudulent actions.

What is coming though is a greater transparency for these trades in the light of global regulatory changes. Will it stop rogue trading? No. One determined individual will always be able to go rogue. What this may do is help banks keep track of “off-market” trading and allow risk managers to do their jobs with good information.

Finally, there is one thing I wish to point out. Speaking on BBC News 24 on Thursday night, I gave a brief summation of the probable trade Adoboli used to get these losses. This in turn was described by the presenter as “a bet”. Well, yes, yes it is. But all investment by its nature is a bet. Unless you have inside information, you have to use your judgement to work out what the probable outcome for the company, share or currency is down the line. This is no different from using the form guide when you pop down to Ladbrokes to bet on a football team or horse.

Investment is a risk, there are always winners and losers, and it is the nature – not the fault – of the system. After all, if UBS is a $2bn loser, somewhere there is a $2bn winner.

Pic credit: This is London

IT'S LEGO BRICKS NOT BRICS

Thought you would like to see this Lego guide to the crisis in the eurozone, courtesy of JPMorgan:

1. The toreador in a floppy hat, and the F1 driver with his helmet, represent Spain, Italy and the rest of the Euro Periphery.
2. The three men with helmets, shields, and medieval weaponry represent the CDU, CSU and FDP parties in Germany.
3. The blue-and-white sailor boy is Finland.
4. The woman with an oversized carrot and her friend in overalls with a shovel represent the Social Democrats and Greens.
5. Wotan represents the Bundesbank.
6. The piggy bank is the IMF.
7. The grey-haired Banque chap is the ECB.
8. The chap in the red bib is Poland.
9. The artists are France.
10. The angry chef, the sweeper with a broom, the airline pilot, and the rest of the motley crew at bottom left, represent EU taxpayers in Core countries.
11. The storm troopers are the EU Commission and Euro Group Finance Ministers, chaired by Jose Manuel Barroso and Jean- Claude Juncker.
12. The monocled banker and his assistant are EU bondholders and shareholders.

BEHAVING BADLY? POLITICIANS V BANKS

Inevitability when something happens; there is a tendency to blame the system itself rather than the behaviour within a system. Grasping for the need to be shown to do something, politicians – backed by hectoring calls from the media - ignore the obvious in favour of introducing more strict regulations or laws. The obvious being, what was the behaviour of the people involved?

From gun laws to dangerous dogs, the effect has been that the lawful have been punished for the actions of the unlawful and the actions, or inaction, of politicians, police and judiciary.

And so it is with banking.

Three years ago, we saw the financial crash that we have yet to recover from. As banks went to the wall and the markets crashed, governments stepped in to bailout other banks.

As a result, the UK government set up the Independent Banking Commission which releases its final report on the future of UK banks in under a week’s time.

In all likelihood, the report will recommend the ring-fencing of the retail operations of a bank from the investment side.

Predictably, in these bank-bashing days, the public and politicians have applauded the suggestion and in fact go even further and want a full-blown abolition of universal banking.

However, it is important to note that, in the UK at least, the major failures in the banking system came from retail operations or takeovers.  Northern Rock and Bradford & Bingley were high-street operations, whilst RBS entered into a disastrous purchase of ABN Amro. In addition Lloyds was a paragon of virtue in banking terms until being forced to take on Halifax.

Those truly universal banks, Barclays and HSBC for example, were relatively unscathed despite having extremely aggressive investment divisions. Barclays even going for the profitable parts of Lehman’s following its demise.

The crash started with sub-prime mortgages – a political strategy from Bill Clinton. It was not casino banking, this was a politically-motivated form of irresponsible lending. When the sub-prime mortgages were repackaged, it was also not just the “Anglo-Saxons” that were caught up on the idea of ever-increasing returns. German, French and Swiss banks were happy to pick up sub-prime debt packages with the promise of monies to come.

The issue was behavioural. Poor risk management and poor decision-making at a time when politicians were making claims for an end to boom and bust and the consumer feeding frenzy was about to hit its peak. Everyone was at it. The politicians, you the public, us in the media, the banks, they were the good times. Only a few were predicting the bubble burst and their voices weren’t loud enough to be heard above the ringing of cash tills and ATMs.

Making a decision, so you appear to be decisive, is not a sensible option unless you look at the events and behaviour within the system.

In 2008, Northern Rock should have been allowed to fail and RBS should have gone to the wall, same with Halifax. This was the moral hazard that Bank of England governor Sir Mervyn King had talked about – take the risk, take the fall. A structured wind-up with depositors and mortgage holders protected should have happened.

This would have given the signal to the markets and the banks themselves that they were not protected, only their customers were. This would have led to a natural change in investment and risk habits rather than the politically-enforced one that is being suggested at the moment.

Although banks, and politicians, doom-mongered about banks being “too big to fail”, my view is tough. The economic world needed an adjustment no matter what. Speaking as one who was hit by the crash, I know how tough it could have been but I would argue that this adjustment could have prevented us from being where we are at the moment, teetering on the edge, lacking a confidence in the global economy.

It is not that some of the ICB’s ideas aren’t sound. Capital adequacy rules are already being put into place through Basel II and the European bank-stress tests, while living wills - to allow an orderly wind-up of a failing bank whilst protecting savers - are good if done correctly. But splitting operations and not allowing banks to cross-finance operations would not restrict risk and indeed could actually hinder not help the British economy.

Investment banking in its own right is not inherently wrong, in fact it provides financing for companies and income for pension funds. The issue is about people and risk. Rather than destroying a structure that rightly or wrongly, plays a big part of our economy, the question has to be about shareholder or investor accountability for management actions, protection for retail savers, and sensible regulation that promotes the recovery, not kill it dead.

With both the US and European leaders rejecting the banning of universal banking, it hardly seems believable that some in Westminster seem determined to go ahead with this and present a Britain which appears completely hostile to investment and finance.

It seems it is not just banking behaviour that carries a risk to the UK.