The Institutional Risk Analyst: Basel II & Bank Dealer Activities: Too Big to Trade

When Citigroup (NYSE:C) CFO Sallie Krawcheck yesterday expressed surprise at the poor results of her organization's trading desk, we were likewise taken aback. After all, is it reasonable for the executive of a public company to have any expectations regarding a venture as speculative as the proprietary trading desk of a large bank? The answer is no.

Fact is, the earnings of the money center banks are growing increasingly volatile as the percentage of their assets and personnel devoted to principal activities increases. Remember an institution named Bankers Trust? This failed bank tried to turn the studied guesswork of risk trading into a business, both for itself and for its unfortunate clients. The results were bad then and very little has changed in the intervening years save the size of the bets being made.

The top three US banks - Citigroup, JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC) - all have the Bankers Trust disease to one degree or another. No amount of Basel II will make this speculative dish palatable to discerning investors. The only reasonable expectation for a trading desk is that it will do badly. That way, when the goddess of fortune smiles upon the twenty-somethings who rule the trading room, then corporate leaders like Ms. Krawcheck may express genuine surprise.

No small irony, then, that as Citigroup was taking its lumps in the market yesterday, the Basel Committee on Banking Supervision (BCBS) issued its final proposal on applying the revised capital framework to certain credit exposures arising from trading activities. The global bank regulatory agencies which populate the BCBS are trying, like Ms. Krawcheck and her counterparts at the other "too-big-too-fail" banks, to convince us that trading is a predictable business and thus a reliable source of LT investment earnings.

The big clue to predicting the current trading performance of large banks is that most of their clients among the rapidly expanding hedge fund universe are showing mediocre performance. Are the "hedge funds" that reside inside the biggest banks really so different from their clients? No they are not. Indeed, trading market opportunities are so poor for the largest players that many hedge funds are jumping into lending and private equity investments, even to the point of factoring defaulted consumer loan receivables for banks.

As Washington & Wall Street reported yesterday, banks are also chastened by a flat yield curve and dull trading markets, and have focused on originating and purchasing residential mortgages for earnings and growth. Indeed, the banks have actually taken share away from Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) in the market for conforming mortgage paper. As W&WS; reported: "US banks may now arguably own a bigger piece of the most problematic portion of recent mortgage originations than do the GSEs."

The GSEs, in turn, likewise have been forced to be increasingly creative to find new opportunities. Our favorite example is the Federal Home Loan Bank of Seattle, which just suspended its stock dividend for this year and next because of heavy losses on its own trading book. It seems that the Seattle FHLB embarked upon a bold strategy of buying the callable bonds issued by the other FHLBs and funding same with 30-year debt.

So next time you hear the CFO or CEO of a large financial institution express shock at the poor results of their traders, ask them why they are surprised. Basel II may be useful to help bankers understand credit risk, but there is nothing inside any of the Basel capital structures going back to the 1980s that will save a bank prop desk or its clients from the zero-sum certainty of trading today's financial markets.

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