David Stoughton of ValueKinetics writes:
Once again much hot air and argumentation between parliamentary committees and city grandees about the right regime for banking governance - or is that regulation, or perhaps structure, or ownership. Who knows, clearly this lot do not? All this talk is put sharply in focus by the return, in some quarters, of mega-bonuses for risk takers.
Here's yet another viewpoint (but I buy this one).
Talking with a business analyst in the city the other day, I encountered a perspective that hadn't previously occurred to me, but that makes perfect sense now I get it. It is, of course, all about those complex products derivatives, and it takes a mathematician to spot it.
Put simply the whole theory behind derivatives and the way risk is priced rests on one fundamental assumption, that of perfect information. A not unreasonable assumption under ordinary conditions of electronic trading. Provided that assumption holds true, risk can be estimated and properly reflected in prices.
The problem arises because the financial instruments that are made possible in this environment hide information, some of them deliberately. For instance the, now notorious, CDOs (Collateralised Debt Obligations) were devised precisely for the purpose of hiding the risk in sub-prime mortgages.
Once the information is hidden the pricing of risk ceases to reflect the reality and the market is potentially destabilised. Under those conditions no-one, and I mean no-one, can or could price the risk or predict the point at which it all starts to unwind (this is not a matter of more rocket science - the system moves from complexity into chaos). On top of that all derivatives multiply any risks many times, so once it starts to unwind the whole house of cards comes down.
Danger, keep out
If this analysis is correct, and it does seem to make sense, then no amount of tinkering with governance, regulation or ownership is going to make the slightest difference. Only banning derivatives might work or, more specifically, outlawing financial instruments that hide risk. But, as my friend pointed out, there are lots of ways in which information can be hidden or its flow impeded, most of them unintentional. So, either the mathematical foundation of modern banking are challenged, or we resign ourselves to periodic bouts of banking instability of unpredictable proportions.
I don't see any politicians who will want to make this case - it would effectively spell the end of banking as we know it, with a reversion to the practices of as long ago as the fifties. A leap too far then for any of the players who have a say in what happens next. It won't be happening any time soon.
So, as I've said before - though perhaps with less clear justification - keep your money under the mattress, or put it in one of the retail banks offered by high street retailers. It's safer there, I promise.