The financial crisis briefly spurred calls for the big banks to be broken apart, capitalizing on the popularized notion of “too big to fail” to argue that any institution too big to allow it to go bankrupt should be too big to exist. The moment passed, all we got was Dodd-Frank, and in the end the banks remain as big as ever. But today we stumbled on an interesting read from Scientific American (yes, even SciAm is writing finance articles now… is this like the magazine cover indicator?) which argues that the financial transactions of big investment banks have started to grow too huge – and too complex – for even them to manage. In other words, they’re too big to succeed:
Much has been written about banks being “too big to fail.” The equally important question is are they “too big to succeed?” Can anyone honestly risk manage $2 trillion in complex investments?
Managing these banks is no longer simple. Most assets now owned have risks that can no longer be defined by one or two simple numbers. They often require whole spreadsheets. Mathematically they are vectors or matrices rather than scalars.
In addition, markets are prone to feedback loops. A bank owning enough of an asset can itself change the nature of the asset. JP Morgan’s $6 billion loss was partly due to this effect. Once they had began to dismantle the trade the markets moved against them. Put another way, other traders knew JP Morgan were in pain and proceeded to ‘shove it in their faces’.
The author contends that the old banking model, when the business was about capturing the spread between the interest it paid on savers’ deposits and the interest it collected on loans, it was relatively easy to measure and manage risk. But as banks grow bigger and seek more attractive returns on their capital, they turn to exotic trades that are much more difficult to manage. When banks grow so large that they encompass a vast, interconnected web of complex derivatives, the effect of uncertainties can begin to multiply. If one item on a spreadsheet with an unknown risk is used as collateral for a bet on another complicated transaction… well, as we have seen – not even Citigroup or JP Morgan can stay in control. (Especially if they continue to use outdated and probably worthless risk metrics like VaR).
While there are no managed futures firms too big to fail, the article makes you wonder if there are some which are “too big to perform.” It has been documented that as programs grow bigger, it becomes more difficult to maintain the same levels of risk and return that they could with a smaller AUM, and in many cases we see a pattern of smaller gains and losses as a program grows. But for CTAs, that path isn’t always predictable. There are giants like Winton that still perform, just on a smaller scale with smaller (by percentage) wins and losses. And there are programs which see more volatility when they get bigger – like John W. Henry – leading to a messy demise.
Fortunately, not even the behemoths of the managed futures world (as John W Henry was in its heyday) are big enough to cause systemic concern when they falter and fall. But the big banks? Well, we saw what their stumbles can do in 2008. So the refrain of “too big to fail” wasn’t enough to bring about a breakup of the banks, but maybe “too big to succeed” will be more effective. At any rate, we aren’t likely to see the call to break up the big banks disappear any time soon, and articles like this may be just the thing to keep the crusade running strong.