Thank you Paul Tudor Jones.  You couldn’t have brought the issue to light more clearly and succinctly.   As the UVA student highlighted in his question to the panel, we have a big elephant in the room.  There are almost no senior women in finance.  And, it is even more dire in the one area that research tells us time and again that women would perform better which is trading.

Sadly, trading is a vastly misunderstood role where often the media and many traders themselves focus on the vast rewards rather than the risks.  Separating the rewards from the risks is where the danger occurs.  A better word for trading is risk management.  You take risks in order to make rewards but you must manage the risk in order to still have a reward.

Research says that women are experts at managing risk. (See Linkedin Post by Susan Shaffer Solovay and Jacki Zehner for several research links)  And more interestingly, in contrast to the statements by Mr Tudor Jones about women being overly emotional, the fact is that women are not subject to the testosterone drivers that often cause their male counterparts to blow up both emotionally and financially.

Unfortunately, most of this research can be probably be called anecdotal and even speculative because the sample size of women in trading roles is woefully small.  One of the few roles which is highly meritocratic is also one of the areas where we aren’t getting enough women in the starting gate.

Thankfully we now know one of the reasons why.  There are too many men who have the same unconscious bias (and in some cases conscious) as Mr Tudor Jones. These are the men who get off the plane when there is a female pilot and complain about female drivers on the road.  These are the men who must have missed the fact that female drivers pay less for car insurance.  And for those that get off the plane, they should be grounded for their wacky view of the world.

As for the “laser focus” required of a trader, has Mr Tudor Jones ever tried to write an email with 3 screaming kids running around the room?  Sounds like laser focus to me.

However, having been a derivative trader for 10 years, I dispute the concept of laser focus being the main requirement.  A trader has to take in information from multiple sources at the same time and process it quickly.  Sounds like multi-tasking to me.  So does cooking breakfast, getting the kids dressed and off to school, reviewing the spelling words for the test that day and responding to an urgent work email all while making sure the baby doesn’t eat the dog food.

Unfortunately, I am now guilty of the same crime as Mr Tudor Jones.  I’ve generalized and stereotyped.  When we can all stop doing that, is when we’ll see the best qualified person for the job get it and succeed, whether that’s a man or a woman.

Toddlers are notorious for scrapes, cuts and bruises.  They run without looking and hit a tree or trip over a toy.  Tears and possibly a tantrum are next but eventually a lesson is learned.  It’s easy to make an analogy between toddlers and financial market participants.  They both scream a lot; “I want” is a common phrase and they have their ups and downs but there is one big difference.  The toddler eventually learns to avoid the things that make him fall down but the financial market participants don’t.

We have just gone through several years of some tough lessons in the financial markets.  Here are a few:  Don’t give credit to high risk entities without some measure of control when things go wrong.  When everyone else is jumping in, it’s probably a good time to jump out.  Yet, in the leveraged loan market, we seem to be steadily making our way back to the loose lending practices of pre 2007 while the private equity investors driving this are paying too much for many of their investments.

While it sounds crazy, it makes a lot of sense in the context of how the private equity markets work.  As the Economist highlighted last week, private equity firms don’t have a choice.  They have a bunch of cash sitting around that they need to invest.  If they don’t invest it, they don’t earn their carry and even worse, they may not be able to raise another fund when the current one matures.  With regard to the investors who are buying the highly leveraged debt with loose covenants off the back of these LBOs, they are in a similar situation.  They have to invest in something that has a return.  With interest rates where they are today, fixed income investors are back to searching for yield, the catch phrase of the pre-crisis market.

Contrary to the implication of the Economist article, it is not about the lack of institutional memory or the fact that lessons weren’t learned from the credit crisis, it is the rational behaviour of individuals who are performing as they are incentivized.  Of course, none of this is a surprise.  The LBO/Leveraged Loan market has boomed and busted several times in the past and it will likely do so again.  The relative size of this market is such that we are generally entertained by the headlines and rarely see it as a source of concern.  However, given that it represents a little microcosm of the larger financial market, isn’t it a good time to analyze the incentives implicit and explicit in the risk decision making process and identify how we might mitigate the pro-cyclical nature of financial market behaviour generally?

The head of UBS recently told a UK parliamentary panel that UBS would “no longer put integrity above profits.” The problem with this statement is that it almost sounds like a choice of one versus the other.  Common business sense says that if we act with integrity, then we have a long term sustainable business.  We also know that if we drop integrity, that we can possibly have larger profits over the short term but we may no longer have a business to run in the long term.  So to some extent, this is a business strategy decision based on a time horizon.  Are bankers focused on the short term or the long term and what do those terms mean in the banking world?  If we look at the trading floor and the specific activity of providing liquidity to clients, the conflict of interest between long and short term thinking becomes very clear.

Recent history says that bankers on the trading floor were overwhelmingly focused on the short term and that time horizon was a few years or less.  In fact the cases that are coming to light specifically point to a time horizon of a year or less because that was the bonus cycle.  The profitability of each trade done in a year was the determinant of the bonus for the individuals responsible for executing the trade.  There are a few points to make clear in order for the issue to make sense.  First is that the profitability of a trade is not determined at the point the trade is hedged for the bank.  It is determined at the point the trade is executed by comparing the executed price to the fair market value for that trade.  Banks deserve to make profits when they provide a service clients, and thus if something has a fair market value of 10 and the bank sells it to the client for 10.5, then the bank has made a profit of 0.5.  That makes sense only if the bank can actually buy the product at 10 in the first place which is not always the case.  Regardless of whether the banks position is hedged or not, the 0.5 is declared the profit.  Second there are many trades for which the profitability is not as simple as looking at the price differential between buying and selling the same product.  This is for tailored transactions as well as many derivative trades.  Thus the calculation of profitability is complicated and often subjective.  This is where part of the conflict occurs.  The person determining the profitability for the bank is often the person who is most incentivized to show a high profit.

When looking at this situation, it is important to note that there is often more than one individual responsible for the execution of the trade.  The individual talking to the client is the sales person and the individual putting the price on the transaction is the trader.  There should be a natural tension between these two individuals based on the sales person wanting to preserve the client relationship for a long time and the trader wanting to maximize profits and minimize risk.  However the incentives and the internal cultural pressures at each institution can turn this tension on its head.  What we clearly see in some cases coming to light is a scenario where both the sales person and the trader are looking to maximize profits and minimize risk to the bank to the detriment of the client.  Hindsight is 20/20 and some of this can be explained by saying that many of the transactions done with clients were done when no one in the market had any idea how risky they were.  It was boom time and crazy to think investing in investment grade credit for example could ever result in the losses we eventually saw.

Today, we should all be thinking about how to make business decisions in a commercial manner.  The economic volatility we’ve now been living through for the past 5 years should have taught us that there is no better business strategy than a long term one.  Why is it then, that it still feels like we have to explain that integrity and profits should go hand in hand rather than be adversarial?

There were a number of interesting highlights which came out of the recent rogue trader trail in London which weren’t surprising.  They can be summarized succinctly by this quote from the Economist on November 24th:  “Take a smart and ambitious person, give him billions to play with, push him to make as much money as he can and do away with adult supervision.”  Anyone who has ever worked on a trading floor knows that this was not a unique situation.  In many banks, traders are encouraged to take risk.  While the order to take risk may not be explicit, it is how traders are incentivized:  Make a return and get paid a bonus.  As risk and return go hand in hand, the result is obvious.  What is less obvious is that proper risk management is side-lined in the drive to make returns.  Risk management teams and their systems are cost centers, not revenue centers and are often treated as such.  The fact that there aren’t more of these types of losses is the bigger surprise.

However, in this period of heightened bank scrutiny and regulatory revamping, the shocker is that the judgement seems to maintain the status quo and once again, the individual takes the brunt of the fall.  Years in prison is a life changer for an individual while the fine for a large bank is a blip on the screen.  The only message we can read from this is that the error is on the individual’s part for getting caught rather than the incentive structure and faulty risk management framework that banks use to make more profits.  We shouldn’t be surprised when it happens again (and again and again).

For the US government to find itself at another crisis point such a short period after the recent debt ceiling debate is astounding.  In 2011, we watched as the US government debated the debt ceiling to the last hour and recklessly raised the previously unthinkable possibility of a default on Treasuries.  This prompted immediate action by S&P, one of the main rating agencies to downgrade the US government to double A rather than triple A.  What was previously a risk-free investment from a credit perspective, was suddenly riskier than Johnson & Johnson or Exxon according to the rating agencies.  Despite the criticism from all sides about S&P’s decision, the fact is that the US government damaged confidence in its ability to act sensibly.  As it happens, this didn’t have a major impact on the role of US Treasuries at the time.  They were still seen as safer than anything else.  In other words, risk is relative.  But it did raise the idea that the US government was not as safe as everyone wanted to believe.

Today, we are back in a similar place.  We’re now debating the fiscal cliff which again raises questions about the US government’s ability to manage its financial situation in a responsible way.  The outcome of the fiscal cliff situation is arguably less important than the near certainty that we’re going to hit the debt ceiling again.  Both Democrats and Republicans have been happy to turn a blind eye to the simple fact that for years we’ve spent more than we earn.  Although an oversimplification, the Republicans get to say “but taxes didn’t go up” and the Democrats get to say “but entitlements didn’t get cut”.  All the while the rest of America and the world are watching the US debt clock rise at a scary exponential rate.  It’s not so much bi-partisan as bi-polar:  the US spends like a big government and taxes like a small one.

This demonstrates a short sighted and arrogant approach on behalf of the US government to the privileged position the US Treasury has in the financial markets.  Having the distinction of being the reserve currency and a safe haven has allowed unfettered spending and borrowing which few other entities enjoy.  But the markets are no longer ignoring these crisis points and the blatant splashing about of cash that the US government can’t pay back without borrowing more.  Investors globally are considering as many alternatives as possible to US Treasuries and the US Dollar.  While some say no such thing exists today, the others say that financial markets are constantly evolving and frankly the US doesn’t feel that safe anymore.

For years now we’ve heard about bankers’ bonuses.  What most of the discussions seem to be saying are that they aren’t fair and that bankers must be doing something bad in order to earn that kind of money.  While that may be the case in some instances, the more important issue is that in most cases, we pay bankers for the wrong reasons.  The more risk they take, the more money we pay them.  Because of this incentive structure, banks operate in a strange hierarchical system which goes along the following lines:  Pay people to take risk; fire people when they lose too much money, and promote people when they make money.  (For more on this incentive system please see previous post.)  While that follows a very simple capitalist approach of “eat what you kill”, it doesn’t make sense in a large financial organization (which provides a crucial service) and creates three huge problems.  The first is that it encourages a “superstar” system which can make the work environment a very difficult place for everyone else.  The second is that it promotes people who are not necessarily any good at management, strategy or organization.  The third is that it marginalizes effective risk management.

The superstar system emerged around 30 years ago when research shows that the pay difference between the top performer and the average performer in organizations grew above 100%.  Amazingly, the banking industry isn’t the worst offender in terms of this difference but it’s still an offender.  What the superstar system causes is a food fight around profitable businesses and a pretence of teamwork.  Training up junior people is secondary to making money and possibly negative because it could create another competitor.  Getting another internal business unit involved because the transaction might have some relevance to that other business is too risky because they might want some of the profits.  The list of negative situations is endless.

Promoting these superstars on the basis of how much money they make is baffling to anyone who has any knowledge of sound management principals.  When people are good at making money in a very narrow sales or trading role on the trading floor, it doesn’t necessarily follow that they will be good at management of any sort.  Whether this is by providing sound strategy or organizational structure around a sales team or by providing risk taking and risk management direction to a trading team it is a different skillset than just being a sales person or a trader.  Promoting individuals who don’t have management skills creates organizational chaos and a difficult work environment for everyone, not to mention loss of profits from missed opportunity as a result.

Finally, the risk management teams and principals get marginalized.  The focus is on risk taking and risk takers, not on risk managers and sound risk management principals.  This results in risk management teams being wary of offending the superstars on the trading floors and not sure of the right questions to even ask.  They are not part of senior decision making and thus given no respect as individuals or as representatives of a crucial function within the bank.  They are running to keep up with innovation in a similar way that the regulators are because they aren’t even at the table when innovation occurs.

Overall, banker’s bonuses create a lose lose lose situation for the bank and a win win win situation for the recipients.  No wonder they are loath to change the system.

If you’re walking down the street and you see a hundred dollar bill on the sidewalk, what do you do?  Do you pick it up and put it in your pocket because this is your lucky day?  Or do you try to find the owner?  Would your answer change if someone were looking?  Now take the analogy and apply it to banking.  That hundred dollar bill on the sidewalk is like the money that bankers are dealing with.  It’s never their money and they have a fiduciary duty, very simply, to do the right thing.  But that doesn’t stop everyone from thinking that no one will notice when they put it in their pocket.  That’s why we have internal risk management and compliance and external regulation.  While the heart might say that people are fundamentally good, the mind says it’s best not to put that theory to the test.

This is why the ranting and raving about the evil bankers is interesting.  It’s not so much the bankers as the system that allowed, and in many cases encouraged, those who were inclined to put the hundred dollar bill in their pocket, to do so.  On the trading floor, there are two key situations which stand out as a problem.  First, banks pay more in bonuses when they make more profits.  Because risk and return go hand in hand, often the more profits a bank makes means the more risk they have taken.  But risk can go two ways, and when it results in a loss, the employee doesn’t have to pay any money back to the bank.  So, it’s entirely in his interest to take as much risk as possible.  To be clear, both the trader and the sales person on the trading floor are incentivized to take risk.  For the trader it is more about market risk.  We’ve all seen the large “extraordinary” losses happen (frequently enough that they are no longer “extra” ordinary), which are caused by traders, some rogue and some not.  For the sales person, it is reputation risk.  They are deciding what types of trades are suitable to be doing with certain clients.  Whether the client has conveniently decided to become less sophisticated after the trade goes sour or the sales person knowingly “stuffed” the client with something overly complex, it is clear that this is a risk that banks take with lots of examples of bad behaviour coming forth both from the bankers and the clients .

This is where the second situation comes in.  The trader has some limits to the market risk he can take.  Those limits are set by the risk management team.  When those limits are breeched without prior approval, the employee should immediately be required to take a two week leave of absence so someone else can manage the risk and identify what is going on.  This rarely (if ever) happens because of the first situation above.  The traders taking the risk are paid a lot of money to do their job.  As a result, they have enormous power within the bank.  A risk management official asking questions or making demands is often not even given the time of day.  Even more worrying are the more exotic financial products where the risk manager sometimes doesn’t know what question to ask.  For the sales person, there are client classifications which are made and suitability questionnaires which are filled out, all driven by the compliance team.  But often these are just box-ticking exercises.   The compliance officer vis a vis the sales person is often in a similar situation as the risk management official vis a vis the trader.  And again, the compliance officer may be afraid to admit lack of understanding of the more complex products and sign off in lieu of looking silly.

Clearly, banks need to nurture a risk management and compliance culture that is more than just window dressing.  Both traders and sales people need to know that someone is watching and that it’s not acceptable to put the hundred dollar bill in their pocket.  More important than that though, is that every young new hire to the bank needs to be taught what is acceptable behaviour and what is not.  When banks hire more senior people externally, they need to question the risk culture that person is coming from and make sure it fits.  Further and more complex, is that the banks need to make the risk management and compliance framework stronger.  But how does this happen practically.  The traders and sales people are paid to say “yes” and they are paid from the profit that the trades generate.  How do you pay risk managers and compliance officers to say “no”?

All bankers are not evil.  But, all bankers are not good either. Unfortunately Goldman feels the need to give this impression prior to the book Why I Left Goldman Sachs being released.  In particular, the word “muppet” was used by the author of the book, Greg Smith, in his open resignation letter to the NY Times in March.  He implied that Goldman bankers referred to their clients as “muppets” and tried to take advantage of them.  Goldman’s response has been to say that 99% of the reference to the word “muppet” when they searched their email archives was in reference to the recent movie and the other 1% were taken out of context.  This response is laughable.  The issue is the focus on the word “muppet” itself.  It’s not the exact word, it’s the meaning of it.  Giving the impression that no Goldman banker has ever tried to take advantage of a client is like saying no mechanic or plumber has ever taken advantage of someone who knew less than they did.  While it’s unlikely that any mechanics or plumbers specifically used the word “muppet” in an email discussing this situation, it is equally unlikely that savvy Goldman bankers did either.

“Kill all the lawyers” isn’t a particularly new sentiment, but today it’s far more common to hear “kill all the bankers”.  Individuals, who one could argue once held a position of trust in our society, are now detested.  As it happens, most people who work in banks, while theoretically holding the title banker, had nothing to do with the global economic crisis, outside of perhaps overspending in a personal capacity.  The bankers on which we should focus are primarily those sitting on a trading floor.

Aside from identifying the right bankers, the bigger question we should ask is how did it transpire that these individuals weren’t aware of the damage they could possibly be inflicting on the world? Why is it that only with hindsight we know it was wrong?  Didn’t they know it was wrong deep down as well?  Had they thought about it in the right context, the answer is probably yes, but the trading floor culture didn’t train these individuals to think that way.  This is primarily because of how people are incentivized to take risk.  Among all the risks taken, probably the most damaging was reputational risk.  While everyone talked about it, it seems that reputational risk was approached along the lines of “if everyone else is doing it, it’s okay”.

Has banking always been this way?  While there are always people looking to take advantage when they can, the scale seems to have changed over the last decade.  To better understand the culture and the incentives on the trading floor that created this situation, read my new book How the Trading Floor Really Works.