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Voodoo Banking Part 2

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Short-term performance, long-term damage.

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Editor's Note: For Part 1 please click here.

Banks also increased their trading activities, especially in derivatives and other financial products. Initially, this was targeted at companies and investors seeking to manage financial risk. Over time it increasingly focused on creating risk allowing investors to increase returns and companies to lower borrowing costs or improve currency rates. As profits margins eroded, banks created ever more complex exotic products, usually incorporating derivatives. Derivatives also increasingly became a way to provide additional leverage to customers.

The development of hedge funds was especially important. They borrowed money (against securities offered as collateral) and were extensive users of derivatives. They also traded frequently and aggressively boosting volumes. Prime broking services (bundling settlement, clearing, financial and capital raising) emerged as a major source of earnings for some banks.

As wealth and sophistication grew, investors increasingly sought investments other than bank deposits or even equity, bonds or mutual funds investing in them. Banks created or purchased wealth management businesses (asset managers and private banks) to service this requirement. The clients of the wealth management units were also major purchasers of securities or financial products created by the banks.

Major banks expanded into emerging markets where similar products could be created and sold to a new client base. Global banks had significant advantages in terms of intellectual property and (sometimes) capital resources over local banks. Profit margins in emerging markets were also larger.

Banks also increased their own risk taking. Traditionally, banks took little or no risk other than credit risk. Over time, banks increasingly assumed market risk and investment risk. Originally, banks traded financial products primarily as "agents" standing between two closely matched counterparties. Over time banks became principals in order to provide clients with better, more immediate execution and also increase profit margins.

Increased risk taking was also dictated by business contingencies. Advisory mandates (mergers and acquisition; corporate finance work) were conditional on extension of credit. Banks increasingly "seeded" or invested in hedge funds to gain preferential access to business.

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Clients often sought "alignment" of interests requiring banks to take risk positions in transactions. This evolved into the "principal" business as banks increasingly made high risk investment in transactions. In some banks, this evolved into a model where the bank acted purely as "principal" rolling back the clock to the days of J.P. Morgan. Banks convinced themselves of the strategy on the basis that the risks were acceptable (it was their deal after all!), the risk could be always sold off at a price (market were liquid) and (the real reason) high returns.

Enhanced revenues (growing volumes and increasing risk) were augmented by increased leverage and adroit capital management. "Regulatory arbitrage" evolved into a business model. Required risk capital was reduced by creating the "shadow" banking system – a complex network of off balance sheet vehicle and hedge funds. Risk was transferred into the "unregulated" shadow banking system. The strategies exploited bank capital rules. Some or all of the real risk remained indirectly with the originating bank.

Banks reduced "real" equity – common shares – by substituting creative hybrid capital instruments that reduced the cost of capital. The structures generally used high income to attract investors, especially retail investors, while disguising the (less obvious) equity price risk. In some cases, banks used these new forms of capital to repurchase shares to boost returns. For example, Citigroup (C) repurchased US$12.8 billion of its shares in 2005 and an additional US$7 billion in 2006.

Banks increasingly "hollowed out" capital and liquidity reserves – that is, they reduced these to minimum levels. Concepts of "purchased" capital and "purchased" liquidity gained in popularity. The theory was that banks did not need to hold equity and cash buffers as these items could always be purchased in the market at a price.

Bank profits in recent history were driven by rapid and large growth in lending, trading revenues and increased risk taking. Banking returns were underwritten by an extremely favourable economic environment (a long period of relatively uninterrupted expansion, low inflation, low interest rates and the "dividends" from the end of communism and growth in international trade).

Bankers would argue that the source of higher returns was "innovation." John Kenneth Galbraith, in A Short History of Financial Euphoria, noted that:

" Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design... The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."

Elite athletes often use performance enhancement drugs to boost performance. Voodoo banking operated similarly enabling banks to enhance short-term performance whilst risking longer-term damage.

Click here for Part 3.

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