‘The Big Short’ Revisited

Towards the end of the just-released movie “The Big Short”, the narrator goes through a brief list of events that have not taken place since that time — including, most notably, the arrests of multiple leading players involved and the down-sizing of large banks. While that may not have happened, a number of positive changes have taken place since then. It is worthwhile summarizing them.

First, there has been a cultural shift at the major banks away from short-term risk taking. Examples of this include the fact that traders’ trading limits are managed more carefully and comprehensively by market risk officers and firms have reduced incentives for traders to take long-term risks for short-term gains. Bonus payments are held back or other punitive actions are taken when traders have been found to have exceeded their trading limits or gone outside of their trading mandate. Since the “Big Short” era, a more aggressive risk officer has come to the fore, one who has a seat at the table when new trades are being discussed. The risk officer’s opinion is treated more seriously by trading operations executives operating under the assumption that that short-term gain is not the only factor in deciding whether to move forward with a trade. Furthermore, Model Risk officers have put in place important industry strength controls that have been able to provide more transparency around new trades, model changes and complex trading activities.

Second, regulatory changes have begun to bite. The Basel III regime has led to significant de-leveraging by US and European Banks and this has taken some important elements of high risk out of the equation. Regulators have a much better view into the liquidity positions of their regulated entities through CCAR and other stress test reviews, deploying their own conservative models to the process. Significant new disciplines around data management and data governance driven by Dodd Frank requirements point to a greater certainty and understanding of the true positions and risk exposures a company really has. The Volcker Rule brought an important reduction directly and indirectly in the role and activity of investment banks in trading investor’s capital in risky assets. Banks that aggressively invested in hedge funds and prop trading desks have closed down those desks and restricted those types of activity accordingly. Swap transactions that used to take place bi-laterally are now moving to exchanges, another reform that was called for after the 2008 credit meltdown.

Third, the business strategy of leading investment banks has changed. One good example is Morgan Stanley whose strategy for several years now has explicitly focused on increasing the proportion of revenues from stable sources…most particularly, Wealth Management and Institutional Trading services. This strategy has borne fruit, exemplified by the successful integration with Citigroup Smith Barney and increased revenue from commission based trading activity, as the level of capital assigned to profit making from complex trading activity has reduced.

Fourth, technologies have been developed that help build a better mouse trap against fraudulent and other risky activities. Cognitive and data analytic computing applications can help identify and mitigate risk in its many forms: anti-money laundering, rogue trading, insider trading and other forms of market manipulations such as spoofing and layering. Firms have invested in these new technologies and it should help. Yet, stuff still happens. In the past year, regulators have announced new investigations across the globe into potential AML violations, market trading manipulations and insider trading activity. So a key test for these new cognitive computing applications is: can they identify risk events and fraudulent activity before they happen? It is too early to say, but cognitive and machine learning applications are becoming much more powerful and closely attuned to such use cases. However, they can only be fully effective if the business, in conjunction with compliance and risk officers, understands and builds effective rules to monitor against.

The narrator in “The Big Short” was not too optimistic for the future and our ability to prevent a re-occurrence of the events of 2008. However, as I have just reviewed, major changes have taken place in the banking sector and it should come as no surprise that more than a few traders (complaining of bureaucracy and compliance over-reach) have left to go to work for hedge funds…organizations perhaps more perfectly designed to take on extreme trading risks.

Will these changes help to protect society from a re-occurrence of the 2008 scenario? Yes. But that is not to say that a different scenario could not emerge in the future. One concern oft expressed, for instance, is that because every decision and action needs documentation, verification and challenge from multiple layers of control functions, time and resources can be diverted from actual risk management and professional judgment. It is to be hoped that banks and regulators will be able to find over time the appropriate combination of risk management and business innovation such that the effects of such a new scenario may be more limited going forward.

I look forward to hearing your thoughts on what has and has not changed…and what you think the future may portend. I can be reached at abwaxman@us.ibm.com


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