WHAT IS THE TROUBLE WITH BIG BANKS?
Once upon a time, banking was very simple. You take money from people and pay them 1 percent interest. You lend that money out at 5 percent interest with a lean on a property that is worth at least 20 percent more than the money you loaned out. You earn 4 percent on other people’s money at virtually zero risk.
Then banks became owned by stockholders, not partnerships. Stockholders began to demand bigger profits. Bankers began to take on bigger risks.
The people handling money at the big banks are very smart. They know ways to make huge profits and they are rewarded very well when they make big profits; the bigger the risk, the greater the reward for these very smart people when they make the right investment.
When these very smart people make a bad investment and the big bank loses huge amounts of money, sometimes make-you-go-bankrupt amounts of money; the very smart person who made the bad investment does not lose any money, he only loses his job. This loss is temporary as there is a mindset on Wall Street that if you are capable of losing enough money to bankrupt a big bank then you must be very smart and you only need to be put under extra scrutiny and supervision. The very smart people who lose huge amounts of other people’s money get rehired for very large salaries.
The result of all this is that very smart people have the incentive of huge rewards to take on huge risks with huge amounts of other people’s money with very little personal risk.
Big bank’s answer to this dilemma is to place these very smart people under the scrutiny of a “Risk Management" Department and stop them when they are taking risks which are unwarranted or unwise.
There is a problem with this model. Risk Management Managers are not as smart as the very smart people taking the very big risks. When a manager who makes $250,000 a year approaches a trader who make $5,000,000 a year and created revenues the previous year of $500,000,000 for the firm, it is a little difficult for him to tell the very smart person that his trades are too risky.
“You want me to stop a trade that is producing huge profits for the firm? Do you even know what you are talking about?”
$5,000,000 outranks $250,000 every time.
These products that very smart people trade are so complicated that risk is super hard to determine:
You buy 5 gazillion shares of XYZ in dollars, and sell 2 gazillion options to buy the same XYZ shares in Euros to hedge the bet, and sell 3 gazillion options to buy 4 gazillion Euros in case the currency market slips and bundle that trade with 2 gazillion dollars of high risk mortgages balanced by an option to buy the Eiffel Tower.
What could go wrong?
A $250,000 a year Manager does not want to admit to a $5,000,000 a year trader that he does not understand the product, so he puts his stamp of approval on it. Six months later they find the Eiffel Tower is in disrepair and the big bank loses 88 gazillion dollars. Big bank goes bankrupt. The $250,000 a year Risk Management Manager takes a job as a Wal-Mart greater. The $5,000,000 a year trader takes last year’s bonus and goes to the Bahamas for six months before taking another job with another big bank which is impressed that he was smart enough to lose 88 gazillion dollars.
That is the trouble with big banks.