A basic model of financial regulation is that it is a game in which (1) regulators write rules to stop banks from doing naughty things, and then (2) the banks sit down with a freshly printed copy of the rules and a bunch of lawyers and find ways to do the naughty things they were doing, plus some additional naughty things, all while technically complying with the new rules. Doing the naughty things tends to be more profitable than writing the regulations, so the banks have an upper hand in this game.
This is, I guess, a pretty cynical model? It doesn't really have to be; many bankers actually think that what they do has social value, so they view regulatory efforts to slow them down as just impediments to progress. "This deal is risk-free and good for the world," they think, "so why should it be prevented by all these arbitrary risk limits?" Bankers are -- in their own estimation -- better stewards of capital than regulators, so it's sort of understandable that they would try to do their jobs with as little regulatory interference as possible.
Anyway that's always been my model and I'm rarely disappointed! Some examples of my absence of disappointment are in this footnote here.* But I was disappointed by today's front-page Wall Street Journal article about Morgan Stanley because boy does it sound like Morgan Stanley is playing the game wrong:
"Your No. 1 client is the government," John J. Mack, Morgan Stanley's chairman and chief executive from 2005 to 2009, told current CEO James Gorman in a recent phone call. Mr. Gorman, who was visiting Washington that day, agreed. ...
By both force and choice, Morgan Stanley has upended its culture and ethos. Go-go trading businesses once hailed as its future are gone or curtailed. In their place, the storied investment bank has embraced the retail-brokerage business -- peddling stocks and doling out financial advice to ordinary investors -- a less exclusive club more often associated with names like Merrill Lynch and Schwab. ...
One small sign of the times: The cigar shop in the ground floor of Morgan Stanley's Times Square headquarters, a favorite of former chairman Richard Fisher, decamped downtown in 2011 because business was poor. The space is now occupied by a bakery that sells minicupcakes.
It goes on and in a sense it's all worth reading -- Sheila Bair, who's pretty cynical about banks, is quoted saying "They're not perfect, but there's been real progress at that bank ... Gorman has really tried to have a safer risk profile." Yet in another sense, you can stop with that cupcake anecdote. Regulatory arbitrage brainstorming sessions are not fueled by mini cupcakes. The ground floor of Goldman Sachs's headquarters has a meth lab. (Not really.**)
So while of course it's possible that this is just next-level perception manipulation and I've fallen for it -- that Morgan Stanley has found a novel way to take on immense amounts of complex risk and hide it behind an army of retail brokers and a layer of cream-cheese frosting -- I think that this story is what it appears to be. Morgan Stanley seems to be de-risking by cutting back on risky activities, and responding to new regulations by obeying them.
That's ... I feel terrible saying this, but that's weird. That's not how it's done. I mean, even now, that's not how it's done: Read the big Bloomberg News piece today about how underminey the banks have been about new financial regulation, or consider the mathematical manipulations that banks resort to to comply with new higher capital requirements. Or ponder how Goldman's been sort of ignoring and evading the Volcker Rule, which bans proprietary trading by banks.*** Then ponder how Morgan Stanley's dealing with it:
Mr. Gorman says he regrets losing one business since the financial crisis -- the firm's biggest and most consistent proprietary-trading desk, a quantitative-investment operation known as PDT. ... In 2007, the firm moved it to new, plusher digs in its headquarters to give it more space to make money. Five years later, PDT shut down, a casualty of the Volcker rule.
They had a business that they wanted to keep, and the rules said they couldn't, and -- they shut it down. What an anticlimax.
It's like Morgan Stanley really believes that the government is client number one, and that their aim is to please and delight, rather than just minimally appease, their regulators. It's a fascinating experiment in part because it is an approach that is not, let us say, wholeheartedly shared by all of their peers. Morgan Stanley will be a good test case of whether a bank can be successful while taking the new regulatory environment seriously in the sense in which it is intended -- and also, perhaps, of whether that approach will actually make it safer.
* Just a couple:
- Regulators required banks to hold capital against certain credit exposures from their derivatives contracts. Credit Suisse minimized that required capital by surreptitiously writing a derivative to itself to cover that credit risk, in a transaction that still makes me choke up from its sheer absurd beauty. (Later regulators caught on though.)
- JPMorgan did some quite astonishingly cynical exploitation of electricity-markets rules recently, basically on the theory of "well we didn't write the rules, did we? You can't blame us if they're dumb and we noticed."
- The Volcker Rule is at this point just obviously a game. "You got us," the regulators probably chuckle, when Goldman finds a way to co-invest in private equity deals that obviously wasn't intended -- though also obviously wasn't expressly forbidden! -- by the rule.
Fanning out from its headquarters bounded by Vesey and Murray Streets, next to the World Financial Center and a block northwest of ever-rising ground zero, there is now a kind of Goldman village anchored by Goldman Alley, as the locals call the public passageway between Vesey and Murray that's shielded by a tilted glass canopy.
In this Goldman-enabled world, any of its 8,000 employees can dart downstairs and acquire spicy onion rings at 1 a.m. Or, if the need arises during the day, pick up a Cymbidium orchid. Or grab a bottle of A. Edmond Audry Tres Ancienne Grande Champagne Cognac.
I assume that that is a flavor of cognac particularly conducive to dreaming up ways around the Volcker Rule. Possibly the orchids help too?
*** Boy you're really gonna hate me when you realize you scrolled all the way down to this footnote only to find out that it's just: see footnote 1. Footnote * I mean. Hyperlinks are coming I sort-of promise! Anyway here's another Goldman Volcker thing for your trouble.
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Matthew S Levine at email@example.com