09.18.11

The End of Wall Street's Big Payday

UBS's 'rogue trader' lost $2 billion of his company's own money—it didn’t really harm investors. The real story is that the era of big Wall Street profits is over, writes Zachary Karabell.

On Sept. 15, a 31-year-old UBS trader in London was arrested for fraudulently attempting to hide “rogue” trades that led to at least $2 billion in losses for the Swiss bank.

The episode was greeted with incredulity. How could a large financial institution, Swiss no less, let its risk controls slip so much that a person in a relatively junior position could lose so much of the bank’s capital? But on multiple scores, the reaction misses the point. Risky trading activity is not rare; it is ubiquitous. It is not unprecedented, and in the wake of the financial crisis that is barely three years past, banks are faced with a choice: Take ill-advised risks in a desperate attempt to maintain the levels of profit that they have become distressingly accustomed to, or become accustomed to distressingly less profit.

This is hardly the first time a large investment bank has faced massive losses stemming from questionable activities by young, presumably ambitious traders. In 2008, the French bank Société Générale dealt with more than $6 billion in losses stemming from trades made by the young and quiet Jerome Kerviel, and in 1995, twenty-something Nick Leeson  infamously brought down the venerable bank Barings Brothers with his ill-calculated trades from Singapore.

Young men taking unwise risks is hardly confined to traders at investment banks, and we shouldn’t indulge in deep commentary on why this particular trader did what he did. In the end, the list of reasons is short: The lure of making more money, impressing his bosses or screwing them, impressing his friends/parents/lovers/exes or showing them that he isn’t a loser, making one bad trade that in turn begets others and an attempt to coverup, those are human motivations all too common to merit deep commentary about the industry per se.

But what does merit discussion—and demands recognition—is that the global investment-banking industry, concentrated as it is in the old financial centers of Europe and the United States, is in crisis. In many ways, it is a deeper crisis than what it faced after the collapse of Lehman. That was a global crisis that demanded concerted action on the part of governments everywhere to guarantee the solvency of major financial institutions. That crisis allowed the major players—of which UBS is one—to attempt a “return to normal.” Yes, risk controls were tightened and the amount of leverage contained, but what didn’t change radically were the expectations of the executives who work at these institutions. They were willing (or forced) to take pay cuts in 2008 and 2009, but few have been forced to confront the gap between their expectations of profit and the potential for it in the world today.

A senior member of JPMorgan Chase recently warned profits for the behemoth bank would fall sharply this quarter because of steep declines in trading revenue and even worse trends in investment-banking business. Those issues are industrywide. With the proliferation of electronic trading, the cost of transactions has been plummeting for years, but during the worst of the financial crisis in 2009, very high volumes partly compensated for lower revenue per trade. Now there is even less activity, as individual investors must either sit tight or sit out, and many institutions are following suit. Investment banking meanwhile, which had been one of the major profit centers, suffers from fewer deals at more modest prices, as well as clients no longer willing to pay the same extraordinary fees.

But while the business is rapidly contracting, expectations have not. Wall Street firms still doled out near record bonuses at the beginning of this year. Executives ranging from JPMorgan Chase CEO Jamie Dimon to Barclay’s CEO Bob Diamond defended the bonus payouts as a legitimate profit sharing in a lucrative industry that served its clients. That’s just the problem, however: There is no way this industry can remain as lucrative as it has been—but there are scores of people who can’t accept that.

Global banking is returning to the norm of much of the 20thcentury, when it was a profitable industry that put capital in motion but nowhere near the scale of the 1990s and the first decade of the 2000s.

In fact, faced with a web of global regulations; very modest yields for fixed income; muted retail and commercial banking in the U.S. and Europe; low returns for equities and lower trade volumes; and emerging banking giants in Brazil, China, and India that are capturing those lucrative markets and engaging in their own capital raising; there is no way that these banks can attain the margins and level of profit that they enjoyed in the late 1990s through the early 2000s. Global banking is returning to the norm of much of the 20th century, when it was a profitable industry that put capital in motion but nowhere near the scale of profitability attained in the 1990s and the first decade of the 2000s. 

But no institution fades willingly. Faced with that trend, denial is natural, and so is desperate behavior. Today’s UBS trading scandal—which saw $2 billion of UBS capital, not client money per se, evaporate—is a symptom of that. We know this because the unit where it happened was supposed to execute a low-margin, lower-risk trading strategy—but that proved to be unsatisfying to an ambitious young man who surely had in mind bigger things and bigger paydays. More to the point, the bank itself had an internal imperative to find some new avenue of hyper-growth to offset its multiple areas of shrinking profit.

Over the next few years, a few solid winners will emerge in banking land, likely JPMorgan Chase among them. These will be less flashy companies with global reach, multiple channels, disciplined management, and most important, realistic and diminished expectations. But in the process, many other companies will struggle and try to fight against history. They will try to keep alive the flame of abnormal profit and either make or facilitate decisions that serve the illusion that the past few years are just a blip.

This episode at UBS hurt only itself. Let us hope that the next blow-up made by bankers chasing a lost dream is similarly contained. But until the global banking system contracts more than it already has, the risk is not that UBS will earn less than expected this quarter, but that the need to take greater risks to maintain unreasonable levels of profits will lead to a new global crisis. For now, the risks appear most apparent in the sovereign, political arena—Greece, Italy, Europe, and the U.S. budgets. But that may mask the still-unresolved risks of the global financial system, risks born of individuals and institutions harboring ambitions that cannot be attained in the world as it is and yet trying to satisfy those, at all costs. The most likely scenario is that these institutions continue to contract and recede, fading with whimpers and not bangs, but like a country losing influence, they can be dangerous on the way down.