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UBS Hit Shows Risks of Casino Investment Banks

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I'm reading about the arrest in London of Kweku Adoboli of the Swiss investment bank UBS. I'm at the Randolph Hotel in Oxford, overlooking Balliol College. I'm here for the Oxford University Reunion Weekend -- 49 years since I matriculated.

It seems that Mr. Adoboli, the young UBS trader, made a $2 billion mistake. Using his super-duper Delta One trading system, he bought Swiss francs as a hedge when he meant to sell them. Before he realized his mistake, if we can believe this, the market ran away with his bet. Swiss francs fell in value and UBS took the hit for a couple billion. This exceeds Nick Leeson's $1.3 billion loss, which brought down Barings in 1995. It ranks third after Jerome Kerviel's $6 billion loss at Societe Generale in 2008 and Yasuo Hamanaka's $2.6 billion loss at Sumitomo in 1996. All this from today's Independent, delivered to my door this morning.

For UBS, the timing is bad. It had just started to show a profit in 2010. So long as no one bails out UBS, the victims are (and should be, based on the published information so far) UBS employees and shareholders.

But for the just-issued Vickers Report, from Britain's Independent Commission on Banking chaired by Sir John Vickers, the timing couldn't have been better. It shows how risky the "casino" banks are, and how frail is their ability to control it. These high-fliers need to be kept away from public deposits.

The Vickers Report recommends reversing some of Britain's "Big Bang" deregulation of 1986 by "ringfencing" retail (commercial) banks with a separate board of directors and shareholder equity that is at least 10 percent of risk-weighted assets. The plan is for new controls to be in place by 2019.

A key element of the Vickers recommendations is that commercial banking and investment banking be separated. This was a central component of the Glass-Steagall Act of 1933, separating commercial banking from investment ("casino") banking.

An opponent of the Vickers recommendations, Martin Jacomb, protested against them in the September 14 Financial Times (p. 15), the day after the Vickers report was publicized:

Commentators speak loosely about going back to Glass-Steagall. But the Glass-Steagall Act was introduced to deal with a problem that no longer exists: the distribution of fraudulent securities to uninformed customers. It was abolished because customers wanted the services universal banks can provide.

Sorry, but that loose statement is just wrong. Let me count the ways:

1. Glass-Steagall was not abolished. The Steagall part, having to do with deposit insurance and insured-bank regulation, is still very much in force. What was eaten away over time was the fence around the banks and the FDIC's ability to contain the problem.

2. Distribution of fraudulent securities to uninformed customers is still a problem. Does anyone believe that the underfunded SEC will prevent any future Bernie Madoff from emerging, or any future misdescribed and toxic derivative?

3. Glass-Steagall was designed to prevent runs on banks. The three-part program of Glass-Steagall was to keep the foxes of speculative banking (the "casino" bankers) out of the chicken-coop of commercial banking, to insure deposits, and to regulate insured banks on behalf of depositors and the federal insurance fund. It has worked well, and for 75 years the FDIC took care of ailing commercial banks without massive external funding.

4. "Customers" did not demand the erosion of Glass-Steagall. The legislative record of U.S. bank deregulation and subsequent actions of investment banks shows the ending of many Glass-Steagall protections was driven by financial speculators seeking access to the deep pockets of commercial banks and (via credit default swaps) insurance companies. There was no customer-driven yearning for "universal banking".

As the Economist said in 1999, the erosion of Glass-Steagall protections should have been accompanied by new regulations for investment banks. The United States government unwittingly became a guarantor of "casino" bankers -- and insurance companies -- without the limitations that came in 1933 with deposit insurance. The failure of Lehman Brothers three years ago showed how perilously far into the commercial banking business investment banks had penetrated. The latest UBS fiasco shows the urgency of preventing a repeat of that situation, starting with implementation of Dodd-Frank.