When It Pays To Be Wrong

By James Kwak

Last week I wrote an Atlantic column about the fundamental reasons why big banks are always screwing up. In particular, given the effects of leverage and the short-term incentive structure, it pays to have lousy risk management systems, and it pays for frontline traders to evade those systems—even for the CEO, in the short term.

Today the Wall Street Journal reports evidence that the London Whale was told by his boss to boost the valuations of his trades; according to inside sources, “the favorable valuations might have been aimed at giving the losing trades time to recover and avoid setting off potential alarms at the bank.”

This is clear evidence for the too big to manage hypothesis: not only traders but heads of trading desks manipulating marks to take risks that the bank as a whole might crack down on. But we’ve known for decades that rogue traders (Nick Leeson, Jérôme Kerviel) are out there. The question is why bank managers don’t do a better job putting in place systems and processes to detect them. The most plausible answer is that they don’t want to because, in the short term, they have the exact same incentives as those traders: they like the risk and the higher expected returns it generates. It’s only when things blow up that they act all shocked.

14 thoughts on “When It Pays To Be Wrong

  1. Exactly, James. They all have the same personal exposure, and all benefit from big bets that pay off when they’re right but are stopped out by central banks and governments if they’re wrong. Why not buy time when things are going against you by lying about the marks — assuming, of course, your position actually can be marked.

    The actual test in all of this — i.e., H(0) — is these positions cannot can be marked, thus the actual risk in specific books, specific desks and specific firms actually cannot be specified. Events culminating in the 2008-09 global market collapse demonstrates we cannot reject the null.

    The inability to reject the null is especially acute if the information set being considered to do these conditional tests is expanded to include operational and regulatory risk (e.g., MF Global, Peregrine, Knight, etc.) . The operational risk is apparent in the firms themselves — who use bluster to mask incompetence and incomprehension of their positions and firms’ risks. The regulatory risk is not what you typically think of when you hear that phrase; here we mean regulatory ineptitude — i.e., regulators incapable of understanding or regulating the markets and firms under their mandate.

    The systemic risk such ineptitude poses to all global markets truly is immense, and likely explains (in a statistical sense) the contraction in risk-taking and liquidity provision in markets worldwide.

    Btw, have you or Simon wondered why the MF Global prosecution has gone dark? It would appear Mr. Holder and Pres. Obama are going to bin this one with the mortgage fraud — Mr. Corzine wasn’t doing anything illegal, they’ll contend … just like every firm in the CMO chain wasn’t engaged in fraud … at least till the statute of limitations runs out on their BFF and best bundler. (Where are these guys when you need to sell a bridge? Oh, wait: They’re writing checks to shovel-ready projects! Tee-hee ….) Pathetic, actually: The greatest frauds in the history of the world are occurring one right after another on Obama’s watch, and nothing happens. This is like 1920s Chicago in the financial markets … guys being rubbed out all over the place and the gumshoes look the other way … amazing.

  2. @ Markets. It’s a disgusting predicament with all the “turning a blind eye” to the massive criminality taking place. Corzine dropped off the radar, and one doubts whether any sanction will ever be levied against him.

    How are regulators policing risk when not even the banks engaging the risk hardly basically understand what is happening?

  3. And what about the mother of all bad risk-management systems, that one which had regulators handing out risk-weights here and there, and because they discriminated so much against what was officially perceived as risky, ended up giving us “L’economia castrata”?

  4. The pool, or should I say ses-pool, of irreponsibility has been well entrenched for a good # of decades. Once rewarded it simply proliferates and wallows in its success, I don’t know how, I never showed any compassion for them, but yet they have thrived around the queen bee, and have a lot of support from a place I don’t understand. Perhaps they are just too twisted in the head, or their hearts have been hardened over time. No, can’t be that, they started at a very young age, and leveraged their irresponsibility too greatly for it to be anyone’s but their own fault, once consequence time arrives.

  5. Per, it is hiliarious imagining the banks as a grand chorus of 18th-century castrati and the regulators as the pope and his court. One can almost see the papal court blissfully smiling as the chorus sings one of those transcendent Palestrina or Vivaldi masses. Mid-way thru the mass, the pope arises and walks around a giant altar swinging a thurible to purify the sacred space. He then ascends the pulpit, and, standing before the assembly in bejeweled splendor, his gold- and silver-gilted regalia bouncing the sunlight thru the huge cathedral, his triregnum (pointy hat) comfortably settled on a velvet pillow, proceeds to explain the mysteries of the universe and conduct the ritual of the mass. … Not unlike Fed congressional testimony or a Treasury press conference when you think of it.

  6. Markets.Aurelius, I was of course referring to the testosterone ban the regulators imposed on the economy, but your interpretation sure has merits too.

  7. It’s tireing to repeat these obvious problems because no matter how hard or boisterous the complaints or charges – it all falls on deaf ears. There’s no way out. There is no balm in Gilead. There is no way to address, redress, or fix these monsterous injustices because the system itself is fatally flawed and toxic. Politicians are spaniels on the payroll and will do nothing to help us or right these horrible wrongs. The socalled justice system is equally purchased, owned, controlled, and systemically corrupt. Wolves are guarding the henhouse. Sharks are policing the bloody waters. There are no legal remedies! It’s kill or be killed. There are no laws, there is no justice, and there is no way by legal means to constrain the wanton abuses of the predatorclass. History proves this point. The only viable option is revolt. Revolution. Dragging the den of vipers and thieves out of their opulent mansions and prosecuting them, real horrorshow street style! They care nothing for us. Why would any idiot care for them.

    Burn it all down! Reset! It could not be worse for the 99%.

    In a world where there are no laws – there are no laws for anyone predatorclass biiiiiiaaaatches!!!

  8. Tragically it does ‘pay to be wrong’ – and that is the quintisential problem!

  9. This idea that “big bets”are in anyway acceptable is absurd on it’s face. Is the global financial system a pokergame, blackjack, baccarat??? Added to the unholy mix are perverse incentives, regulatory, judicial, and political bribery – I mean capture, and a total lack of accountability and culpability for wanton failure and systemic criminal activity. We either operate in a sound financial system bound by the rule of law – promoting and encouraging
    innovation, stability, and sustainable markets – or we operate in a casino , where all bets are off and cheating, lying, and stealing are pervasive.

  10. It sounds like Jamie Dimon was making the same calculation as Leeson, as described by Kindleberger in Manias, Panics, and Crashes:

    “Leeson probably made four or five losing bets in a row. Consider the probability that he could have made five successive losing calls on the traditional coin-flip–a run of five heads in a row is a 1 in 32 chance. If he had won just one of the bets, his misadventure would not hae made the front pages of the newspapers and he would not have spent two years in a Singapore jail.”

    Kindleberger concludes:

    “The likelihood is high–very high–that there have been other rogue traders who started like Leeson and Rusnak and incurred losses on two or three or four or their “double or nothing” bets before winning again. The bank’s capital would have remained unaffected and their illegal and fraudulent behavior would have gone undetected.”

    Unless, I suppose, it had been detected and encouraged.

  11. TonyF..
    Couldn’t agree more:
    We either operate in a sound financial system bound by the rule of law – promoting and encouraging innovation, stability, and sustainable markets – or we operate in a casino , where all bets are off and cheating, lying, and stealing are pervasive.
    But how?
    I’m afraid you right with your previous post also..

  12. The corruption is much more fundamental than that. In his Atlantic article, Mr. Kwak states, “Sure, there’s a lot of money in banking, but that’s not all there is to it. There’s a lot of money in Silicon Valley, too, and we don’t think Google and Apple are corrupt>”

    We should start thinking in those terms. When the Fair Accounting Standards Board allows fraudulent, off-balance-sheet accounting, no corporate annual report can be believed.

    And there is no reason other than the deception of investors, the “management” of perceptions about the financial condition of a company, for such accounting gimicks. In other words, fraud is the ONLY purpose of off balance sheet accounting, special purpose vehicles, and all the rest of the accounting industry’s standard practice.

    No, fraud and corruption is at the core of the global business model. As Frank Partnoy rightly comments, until we address THIS issue, all other financial regulatory reforms will fail.

  13. another from the Atlantic

    “If a developer cut corners writing code, it wouldn’t have made it past our automated testing setup — assuming it made it past our other levels of code review — and she wouldn’t have had the incentive, anyway. The closest analog would be a sales representative who tried to give a customer non-standard terms to win a deal. For example, promising a product would do something that our development team hadn’t signed off on. But we were small enough that every contract was reviewed by plenty of managers to make sure that didn’t happen.”

    Has Mr. Kwak forgotten the dot com metldown? It is very easy for a CFO and CEO to collude with programers to scam the system. It’s not the London Whale but it’s destructive fraud nonetheless.

    The incentive is in the stock options, and the ability of executives to manipulate share price with off balance sheet accounting. Mr. Kwak fails to see the extent to which the financialization of the economy has progressed so far. GE makes more money from its financial department than it does selling jet engines and light bulbs. This is the point that Karen Ho makes in Liquidated. Wall St. has forced its business model on the corporate world, starting with the junk bond merger mania of the 1980s. The perverse incentives are pervasive.

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