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Saturday, 25 October 2014

Like land mines? You’ll love investing in banks

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As if we needed more proof, Standard Chartered has demonstrated again the folly of investing in our largest banks.

James Saft, Reuters Columnist

London-based bank Standard Chartered on Monday was accused by New York regulators of hiding 60,000 transactions with Iran, totaling at least $250 billion, an offence which puts them in danger of losing their New York license and ability to clear funds through the U.S.

Really at this point investing in the biggest banks is like burying land mines in your own front yard while blindfolded.

When a senior New York banker warned his higher-ups of potentially “catastrophic reputational damage,” according to the state regulators report, the riposte from London was stunning:

“You f—ing Americans. Who are you to tell us, the rest of the world, that we’re not going to deal with Iranians.”

Standard Chartered said it was “conducting a review” and “discussing” matters with U.S. authorities. Its shares fell 6.0 percent in after hours London trading and doubtless will carry on falling on Tuesday.

“In short, Standard Chartered Bank operated as a rogue institution,” Benjamin Lawsky, superintendent of New York’s department of financial services, said.

And while Standard Chartered reaped hundreds of millions of dollars in fees from the transactions, according to the complaint, much of which will have walked out the door in compensation tied to revenue targets, the potential damage is enormous. A global bank which cannot operate in New York and has had its clearing privileges in the U.S. suspended, as New York is threatening, is no longer a global bank.

While these are allegations, and may not result in any penalty, we once again have an apparent example of bad behaviour, excessive risk taking and poor controls within a bank. This appears, frankly, to be endemic within the industry, and to be more highly distributed at the larger institutions.

When all is revealed, my guess is that this will prove to have been driven by poor compensation practices, and made possible by complexity within the bank. Compensation is at the root because it provides the motivation for risk taking. Because doing banking with Iranian institutions is not allowed, that business, like the drugs business, produces terribly high margins. Those within a bank making the decisions benefit disproportionately from the money as it flows, and unless they face personal criminal charges or compensation clawbacks, they do not share equally in the risks.

Complexity is key because complex products are easy to manipulate to favour insiders, and because they are hard to manage. While the services Standard Chartered is alleged to have provided were not complex, the size of the bank makes it all but impossible for even well-meaning top executives to control. That said, the complaint alleges that the highest levels of Standard Chartered management was aware of deliberate record falsification.

WHO ISN’T INVOLVED?

Three weeks ago, in the wake of the Barclays LIBOR affair and JP Morgan’s trading fiasco, I wrote a column essentially arguing that the largest banks were too big and too risky to be managed in investors’ bests interests.

JP Morgan’s woes, while not large in scale, clearly demonstrate the near-impossibility of managing an operation of its kind, as well as once again showing that traders will do stupid things to earn bonus money. Barclays has a similar lesson, though the ethics of manipulating LIBOR rates were far worse.

Amazingly, in just these three weeks both Standard Chartered and HSBC have been accused of grave, and expensive, violations. HSBC has been accused, by Mexican regulators and a U.S. Senate committee, of laundering money for drug dealers. HSBC has set aside $700 million to help cover fines, settlements and other expenses in relation to the enquiry. Oh, and HSBC reserved another $1.3 billion to cover the costs of a mis-selling scandal involving payment protection plans. Oh yes, and a Senate panel in July found HSBC was used by Iranians attempting to evade sanctions.

The picture this all paints is of a section of an industry which is out of control, and which abuses all of its major stakeholders, save employees. Shareholders have seen terrible returns, consumers suffer from overly complex products and the countries which provide the largest banks with their financial safety net see their laws flouted.

Ending too big to fail would help; it would cut the banks down to a more manageable size. So too would compensation reform, including making very long-term compensation and claw backs a standard feature of senior contracts. Finally, forcing publicly insured banks out of the investment banking business will remove an unfair subsidy, and simplify the regulation of those institutions which must have public insurance.

That will take a long time; until then shareholders ought to leave what is obviously an abusive relationship.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

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