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'The move away from transactional banking and back to a relationship system is thus likely to be gradual. However it is so clearly in the interests of both clients and the global economy as a whole that we can hope it is inevitable in the long run.'</blockquote>
The downside of transactional bankingBy Martin Hutchinson
March 22, 2010
SourceThe news that four banks are being charged with fraud for their sales of derivatives to the City of Milan was no doubt met with derision in trading rooms across the globe. Yet the prosecutors have a point, as does a similar prosecution relating to Jefferson County, Alabama, or potentially one in relation to the off-market swaps sold to the Greek government. The whole question of a bank's relationship to the companies, governments and individuals with which it does business is brought into question by the prosecution.
Under traditional relationship banking, the banker had more or less exclusive dominion over a client, and consequently was held, mostly by market custom, to have a fiduciary duty both to that client and over that client's operations. Thus when Barings was forced into bailout in 1890, the bank's name was besmirched not only because it had foolishly lent money to Argentina, but because as merchant bank advisor to Argentina, it had failed to exercise adequate restraint over that country's incorrigible desire to develop its economy by borrowing excessive amounts of foreign money.
The relationship banker was supposed both to exercise some control over the client's operations and to provide advice and transaction services that were beneficial for the client. This relationship meant that the client itself did not need to be particularly financially sophisticated; it could rely on its relationship banker to advise it on the best course of action and to arrange any transactions that for operating reasons it wished to undertake.
This all changed from the late 1970s with the move to transaction banking. Under transaction banking – a typically aggressive American sales-driven approach to the financial services business – there were no longer any client relationships. Every transaction was competed for on the basis of price; the only deals where you didn't have to compete were ones where you had devised some complex derivatives structure that others didn't have which was irresistibly appealing to the client. Otherwise, it was matter of who gave the financing at the lowest cost in debt deals, or at the highest issue price in equities (investment banks not being completely foolish, there was little competition within the U.S. investment banking cartel over the bloated commission spreads on equity issues.)
This may initially have looked attractive to clients, but in reality it was highly destructive to the ethical standards in the financing business. No longer could clients rely on their merchant/investment bankers to give them good advice, or to protect their interests in general. That meant that every medium-sized company, every dozy municipality, had to build itself a full-fledged finance capability, if only to guard against the piranhas in the finance pool. When Baschi, an Italian village with a population of 2,800, is lured into damaging derivatives transactions that end in lawsuits, the system is broken. The losses suffered by Procter & Gamble and Orange County in 1994 demonstrated quite early on the dangers of operating with a finance staff that was less sophisticated than the sharpies of Wall Street. Needless to say, this additional staffing was extremely expensive for the economy in general, while bringing little benefit in terms of real value added.
The changes the new order had brought were illustrated very early, in the derivatives activities of the U.K. local authorities. By 1983, interest rate swaps had become a well understood tool, and so swap dealers went round the U.K. local authority finance departments selling them. Since they had no fiduciary relationship with the clients, they dangled before the dumb but greedy local finance officers the possibility of lowering their borrowing costs by swapping their fixed rate debt into floating rate debt. Of course, while saving money in the short term, that approach dumped a load of interest rate risk on local taxpayers.
Since I was running a derivatives desk at the time, I quickly came across these transactions. However, I was also a local taxpayer in the London Borough of Islington, a highly corrupt one-party polity that had already been very active in this market. I therefore issued an edict that we would not do swap business with U.K. local authorities, and carried that edict across to my subsequent employer in the same business. You can imagine my mordant satisfaction some years later, when in 1989 the High Court declared all the swap contracts with local authorities to be ultra vires, i.e., the local authorities had no power to enter into them, thus leaving the banks who had sold them with over $300 million in losses – real money in those days
The British local authority deals were mostly plain “vanilla,” not involving spurious upfront payments. However, in many of the Italian and Greek cases, spurious upfront payments took place, by which the governments made their figures look artificially better before elections or in Greece's case before its entry into the European Monetary System. Essentially, the arrangers of those deals were accessories to fraudulent accounting, just as if they had assisted Bernard Madoff to present acceptable figures to his investors each year.
However, randomly declaring contracts invalid post facto is not the answer – it would bring an altogether unwelcome level of uncertainty into the financial services business. After all, precedents were set in the P&G and Orange County cases, that deals sold to an institutional borrower, presumed to be financially competent, by unscrupulous swaps dealers must be honored. There is no usable line that can be drawn between the British local authorities, today's Italian local authorities and Greece on the one hand and Orange County on the other that would allow us to permit one set of deals to stand while the other falls. Certainty in financial contracts is an essential, even when the results are wholly deplorable.
The solution is for the financial services business to revert to an advisory model rather than a transaction model, in which the bank arranging the deals has at least a modest fiduciary duty to its client in two ways. One is to assure the welfare of the client itself, recommending transactions that benefit the client and avoid those that don't. The other fiduciary duty is to prevent that client from ripping others off. Goldman Sachs in the 1980s were advisors to Robert Maxwell at a time when he was looting the assets of the Daily Mirror pension fund. To the extent Goldman knew about Maxwell's activities, it had a duty to impede them; it certainly had a duty to avoid transactions that assisted Maxwell in his depredations. Similarly, in the case of Italian local authorities and the Greek government, banks had a duty not to assist local politicians in using obscure financial market transactions to falsify their accounting or to load risks either onto future local taxpayers or onto EU taxpayers as a whole.
Reverting to relationship banking is easier said than done. Trading activities of all kinds have been so profitable in the last 30 years that only a lunatic would suppose the major financial institutions will retreat from them easily.
Nevertheless, there are some positive forces. For one thing, the current model – in which trading behemoths provide financial advice to clients as a minor part of their business while reserving the right to short the client's stock and take out credit default swaps betting against its survival – is pretty clearly broken as far as clients are concerned. Businesses and the public sector need to get financing, and they prefer to do so without having to deal with institutions with the business ethics of the Cosa Nostra. Just as the most aggressive used car salesman gets only a moderate percentage of the business from the most foolish customers, so the more intelligent corporate treasurers, faced with the possibility of losing their jobs if they allow themselves to be ripped off by some cleverly designed scam, will use every effort to find financial advisors who are not trying to play these games. That's the rationale behind the rise of the “boutique” advisory firms, and the continuing survival of firms such as Rothschild's and Lazard's that have continued to do business more or less in the old fashioned way.
The 2008 disaster has not removed the credibility of the major houses, even though it has made them very unpopular, but the next financial crisis may well do so. For one thing, it is likely to be accompanied by sharply higher interest rates and tightened monetary policy, in which case banks will no longer have the option of trading themselves out of losses by borrowing short, lending long and relying on the Fed to maintain an over-stimulative monetary policy. For another, every deal that gets done without the assistance of the big behemoths is another reminder to the markets that their assistance is not strictly necessary. Deals can be done with the help of medium sized or even small entities, provided those entities have the necessary breadth of investor contacts to place the paper.
The move away from transactional banking and back to a relationship system is thus likely to be gradual. However it is so clearly in the interests of both clients and the global economy as a whole that we can hope it is inevitable in the long run.