If investment banks were casinos - October 2010

Name drop if I must, but at this year’s Labour Party conference I got into a conversation with Eddie Izzard about casino banking. I complained that the term was very unfair to the casino industry as it implied that casinos operated without any rules. My point to this slightly bemused comedian was that casinos are incredibly well regulated unlike the financial industry. Everybody knows the rules of the games being played and everyone is playing with their own money and not the house’s. Very unlike what happened in the recent financial disaster that nearly catapulted this country back to bartering with chickens if the government hadn’t rightly pawned our future to prevent it.

Eddie (as I presumed to call him) and I were being wrangled into the VIP seats for the leader’s speech, although it would turn out that the celeb VIP seats would be 100 yards nearer the stage than the non celeb ones and we would be forced to part, but for five minutes, the multi-marathon cross-dresser couldn’t get away, so I pressed my points home. If the banking world had actually been run like the British casino industry has been for the last 40 years, it’s doubtful whether we would be suffering the biggest government deficit since the second world war or the obscenity of bankers still getting paid billions in bonuses while the country’s most needy have their welfare state cut away from under them. Although he may have been looking for security by this point Eddie seemed to listen, I argued that if some aspects of the casino world were to be imposed on the finance industry, we wouldn’t have been forced to privatise reward and nationalise risk.

Firstly, I shrieked above the conference hall hubbub, you need a strong regulator. Not one with a light touch or one which excuses itself as market driven (i.e. the market will do its job for it), but one which is omniscient and omnipotent. One which realises that in businesses dealing with lots of money there will always be temptation and those who will be tempted. One which puts fear into the people it regulates and spits them out and punishes them publicly if they give in to the temptation. No one would ever consider the FSA in these terms; it has never had the muscle or the clout. This is partly the fault of its enabling legislation but also partly due to the fact it was going up against some of the world’s best brains while it was only paying public sector salaries. Even if it could find the evidence of criminality in the byzantine world of international finance, it had little effective teeth in dealing with it. Fining companies tens of thousands of pounds while they make millions per day is not a very effective deterrent.

With powers from a different generation, the Gaming Board for Great Britain regulated casinos for nearly forty years without any significant disaster. Its ability to end a career or close a business for even the most minor of offences was enough to ensure the industry stayed in line and its members stuck to the rules. There was basically no crime in UK casinos during this time, something practically no other casino jurisdiction in the world could claim. Subsequently the British casino industry became the envy of the world and its regulation copied globally. Yes it was authoritarian and yes, at times, dictatorial, but it worked. Could the British financial industry claim the same in terms of probity? Unfortunately the Gaming Board was replaced in 2007 by the Gambling Commission, a prime example of New Labour’s penchant for toothless market driven bureaucracies as regulators. Since then the gambling industry has been up in arms about the Commission’s timidity and is demanding a tougher and more effective regulator. When has the British banking industry ever asked for more and tougher regulation? The gambling industry knows that tough regulation is a barrier to entry and a selling point of its industry. Conversely, British banks keep warning that if any changes are made to tighten the regulatory environment they will decamp to another location with looser rules and weaker regulations. In gambling parlance, you don’t always want to play with people who want the loosest rules in town. Can’t we make tough banking regulation a selling point?

Secondly, and by this point I suspect Mr Izzard was drawing on the reserves that got him through the pain of running 1,000 miles, you have to know the rules of the game and only play those games. In casinos across the world, only certain games are allowed. You can’t turn up and demand to play a homemade variant of gin rummy that has been passed down the generations where tens are wild and you have to take a drink if you get a pair of deuces. You play certain authorised games, with set rules, which everyone knows and if you don’t, they will let you have a copy before you play. That way, everyone knows the odds they are dealing with.

It would appear that one of the major recurring problems of investment banking is that every now and again, bankers invent financial instruments which they don’t fully understand. Even if a few people do, they tend not to fully realise what will happen to these instruments in a full range of circumstances, they don’t ‘stress test’ them properly. This is what happened in 1998 when a group of Nobel Prize winning economists turned bankers called Long Term Capital Management, failed to factor in the effects of the Far East and Russian financial crises and nearly brought down the US economy in 1998. The US government had to bail out the banks with billions. Does this sound familiar?

The US sub-prime mortgages crises nearly a decade later turned into a global financial disaster because of the way these high risk mortgages had been bundled up and sold to banks around the world in financial packages (mortgage backed securities) that were to be described later by the leaders of the G20 as “increasingly complex and opaque”. The underwriters, rating agencies and investors whose job it is to assess the risk of such products, modelled the correlation of risks amongst the loans in the securitisation pools using an overly simplistic and flawed method, based on the "Gaussian copula" technique. Unfortunately this would prove to be a flawed approach as recent history has shown, the risks were higher then everybody thought. So the bankers didn’t fully understand the risks, or the game they were playing and so lost vast amounts of money, which we have had to pay back . That’s what the nationalisation of risk is. The fact that they keep getting bonuses is the privatisation of reward.

A strong regulator should designate what financial products are to be used by the banks. If they want to use new ones, they should be submitted for testing and then have a ‘thorough stress testing’. This is what happens when you want a new casino game; the regulator tries to ensure that when the improbable happens, the game rules and game outcomes don’t cause the casino to go bust. Surely we could do the same for investment banking?

Another technique for having casinos not going bust is to ensure they have a gaming reserve. This is a deposit in cash or even an insurance policy that ensures that the casino company can pay out winnings should someone have a particularly lucky streak. This is worked out on a table by table basis; for example if the casino offers one roulette table, then it must have a reserve equal to 5,000 x the maximum amount allowed to be staked on a single number. This would enable someone to paid out over 140 times. The main reason why British banks had to be bailed out was that they couldn’t cover their losses on their securitised mortgage debt. If, as I suggest above, all financial instruments have to be authorised by the regulator before they are used, it wouldn’t be difficult to ensure that any potential liabilities are covered by such a reserve. It may tie up a bank’s capital, but surely that’s what the Basel III negotiations are on about?

By now the Labour Party official was pointing Eddie to his seat next to the stage and beckoning me to the back of the hall where the lack of light would ensure no camera picked up my manic visage as I hit my final point; players in the casino must play with their own money.This isn’t a casino rule. It’s quite usual for professional gamblers to have investors who provide the bankroll. This is a response to the uproar that banks were using customer deposits to play in the ‘casino’ that is investment banking. Obviously this is far more risky than the traditional banking model of customer deposits being used for customer mortgages and loans. However, I’m certain that to ban this would lead to a two tier model of banking, retail banks offering minimal returns while those with significant funds would be reaping the rewards of investment banking. Let us not forget that when it works, it’s a great way of generating money A casino-style approach would be to first; let customers decide whether they want some or all of their bank deposits to be used for high risk and high return investment banking style investments or for low risk low return retail banking like loans and mortgages. This, like when choosing which table or slot machine to play, allows the customer to determine his/her own risk profile that is right for his/her savings.

The focus should then be on the actual players in the banking casino. Much has been written about risk crazed investment bankers whose only interest is in short term gain that directly affects their enormous bonuses. All very true and all basically the same as their compatriots in any casino. People indulging in risk for the opportunity of financial return. The difference is that these players have no ‘skin in the game’. Sure, if they make consistent losses they will be leaving the banks employ pretty sharpish, but in general, they only have to do better than average to be on the road to becoming a millionaire. There is no downside to their actions, thus excessive risk taking behaviour is generally encouraged. So to bring in a personal check and balance on overly risky behaviour, we should make all investment banking institutions unlimited liability partnerships (as they were until 2001) and their bankers, partners. This will then make all of those involved personally liable for their own actions and that of their colleagues. If the banks were then to run out of money, the bankers would have to sell their houses, yachts and Ferraris before the government would be forced to step in. It probably wouldn’t generate enough to bail a bank out in a crises but the threat of poverty for these individuals should temper their behaviour and hopefully prevent the default in the first place.

Admittedly Eddie was yards away talking to Tracey Ullman by the time I reached my conclusion and it was a very bewildered Labour Party steward that had to endure that coup de grace. As a society we must accept that renaissance mathematicians such as Cardano, Pascal and Galileo provided us with the tools to look at risk, through probability and statistics. This work provided a number of new business opportunities; casino gambling, financial speculation (the precursor to investment banking) and insurance. They all have the same mother and father and all provide rewards to the brave and losses to the foolhardy or the just plain unlucky.

Rather than considering casino gambling as separate entity, given our recent financial history, we should look on it; its regulation and practice as a decent model for basing future financial regulation. If banking really were done like it is in a casino, then it would have been the government, as the ultimate House, which had won over the last few years rather than the banks and bankers.