'Big bet' banking has to go

By Money Matters Editors

What’s another aspect of banking that has to change? Banker attitudes toward banking.

Earlier, Money Matters wrote about how the ‘heads the banks win, tails the taxpayer pays’ philosophy has to end. That has to be accompanied by an end to another problematic industry practice: excessive risk.

Here’s how banking stands now. Banks encourage trading and loan officers to take excessive risk. For example, bank professionals will design complicated, derivative-based trading programs designed to take high risks: if the risks pay off, the bank wins and racks-up huge profits. If the derivative fails, the bank professionals are fired. Then they find another job with another bank, doing the same thing, doing the same thing, and the whole process starts over again. 

In any event, there’s little incentive for taking low risks: if the bank professional devises a low-risk derivative that earns low profits, he’s going to be fired for not earning enough money for the bank. Hence, one can see why bankers, particularly those involved in trading, take high risks: that’s the industry standard.

The problem occurred when, in this decade – as the recent global financial crisis demonstrated – those high-risk bets not only jeopardized a bank unit, or a large bank,….but the U.S. and global financial systems. For a case study, see: American International Group (AIG). In theory, AIG was a large insurance company, but in practice it was the world’s largest hedge fund. As a result of AIG’s reckless, high-risk bets, the U.S. government and American taxpayers will be paying hundreds of billions of dollars to help AIG unwind positions, pay debts, and otherwise settle obligations, all with the goal of taking risk out of the system in an orderly fashion, without causing another freeze-up in credit markets and/or a U.S./global financial meltdown. Risk, that is, that AIG should not have been allowed to undertake in the first place, but was in fact, encouraged to take, due to banking’s culture.

The U.S. Congress must pass financial system reforms that prevent any bank or financial institution – if they pose a systemic risk – from establishing any position or system – short-term or long-term - that contains excessive risk, and we’ll let the new Financial System Risk Regulator determine what excessive risk constitutes.