The real lesson of rogue trading

Massive bets on the markets; testosterone-fuelled trading floors; 30-year-old traders raking in a million a year through trading instruments so complex you needed a couple of PhDs in physics to understand what they were, never mind what price they were likely to hit the following week. The UBS rogue trading scandal was like something out of the mid-noughties.

But hold on. We thought finance houses were meant to have given all that up. In the wake of the credit crunch, investment-banking giants were meant to have put in new risk controls, beefed up their credit ratios, and gone back to making money the old-fashioned way by servicing their clients with products they actually want. Unfortunately, it turns out they haven't given up frenetic trading at all.

The real message of the Kweku Adoboli affair isn't that UBS has useless risk controls. Nor is it that the traders are back to their old games. It is scarier than that. The lesson to be drawn is that the investment banks no longer have any real business left that doesn't involve taking massive and irresponsible risks.

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The losses suffered by UBS appear to be rising by the day. On Monday, we learned that the total bill was $2.3bn as the positions taken by Adoboli were gradually unwound. It might turn out to be a lot higher. After all, it seems UBS didn't have any clue what its trader was up to. Who knows what contracts might be stuffed behind a radiator somewhere?

Adoboli may be under arrest and whether he misled his bosses at the bank remains to be seen. We'll find out at the trial. What is extraordinary is that UBS is still in the business of allowing 31-year-old traders in effect to gamble with the entire balance sheet of one of Europe's largest banks without much in the way of adult supervision.

This, remember, was a bank that had to be bailed out in the credit crunch to the tune of $46bn, including a massive injection of funds by the Swiss government. If any institution had learned the importance of running its business more responsibly, you'd think it would be this one. But apparently it hasn't. It paused for breath for a few months, then went straight back to doing precisely what got it into so much trouble in the first place. The interesting question is why it didn't learn the lessons? The answer, I suspect, is because it couldn't at least not without concluding that it needed to wind itself up. The possibility is that banks don't actually have much real work left.

Investment banking used to be a real business. The finance houses arranged stock and bond issues for companies. They provided advice on mergers and acquisitions. They arranged new flotations and offered research for fund managers. They may well have been overpaid for much of the work, and a lot of what they did may not have been as useful as it was cracked up to be. But they performed a clear economic function.

Over the last decade, however, all that has changed. The banks turned themselves into massive trading operations, gearing up and betting their balance sheets in the market. There is a problem, however. Trading is essentially a zero-sum game. No fresh wealth is created. The money is merely recycled around the table, much as it is in a game of poker. During the credit bubble of the 1990s the banks could get away with that because the massive creation of debt meant that new money kept coming onto the table, which could then be shuffled around, creating the illusion that everyone was winning. Now that is no longer true. One bank's gain is another bank's loss. So trading is simply too risky. Whatever you make in one year will simply be lost in the next.

So the banks should be scaling back, and going back to what they used to do. But there's a snag. The old-fashioned core business of investment banking can't possibly sustain the lavish operations it has built up. There is practically no significant mergers and acquisitions (M&A) work and not much sign of that reviving. The initial public offering business has stalled. Broking used to be profitable, but margins have been hammered by electronic trading. The spreads are too narrow to pay for decent salaries, and certainly not the kind of money investment bankers expect to pay themselves. All the activities that had an economic function are either unprofitable, can be done better by someone else, or are simply too small to support the massive operations that banks have become. They had to go back to high-risk trading or close down.

No organisation voluntarily closes itself down. Its DNA, just like the DNA of human beings, is built for survival. After the credit crunch, UBS should have focused on building up its successful private banking and wealth management unit, and doing a bit of broking and M&A advice on the side. It couldn't because it would have meant substantially shrinking in size. Much the same is true of all the other investment banks. The implication? Much of modern investment banking may simply be too inherently risky to be allowed to continue. Once you take out the gambling, there isn't much left. But the banks won't wind themselves up. So perhaps the regulators should do this for them?

This article was originally published in MoneyWeek magazine issue number 556 on23 September 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, sign up for a three-week free trial now.