For people who don't work on Wall Street, proprietary trading comes across as a mercurial but highly profitable activity that has transformed countless hedge fund managers and investment bankers into multimillionaires, if not billionaires. Yet according to a recent study by a prestigious international organization, when trading is coupled with traditional banking, the results are almost categorically disappointing.
The illusory benefits of trading
In its latest quarterly review, the Bank for International Settlements, a Switzerland-based regulatory body that coordinates international financial rules, set out to determine whether there are systematic differences in the performance of banks with different business models.
To do this, it classified more than 200 global banks into three categories. The first consisted of retail-funded banks, which accept deposits from people like you and me, and then lend the funds out to individuals and businesses that need capital. The second included wholesale-funded banks, which use funds from other financial companies to make loans. And the third category was made up of capital markets-oriented banks, or trading banks for short, which hold at least half of their assets in tradable securities and are funded, like the second group, in the wholesale markets.
The researchers then set out to identify which model performed the best from 2005 to 2013 based on a variety of key metrics. And while there were pluses and minuses to both retail and wholesale banks, the companies that engaged heavily in trading activities evidenced extreme volatility in earnings and no overriding positive traits. "On average, retail-focused commercial banks exhibit the least volatile earnings, while wholesale-funded commercial banks are the most efficient," noted the authors. "On the other hand, trading banks struggle to consistently outperform the other two business types."
Take profitability as an example. While the earnings fluctuated for all banks between 2005 and 2013 -- as one would expect, given the 2008 financial crisis -- return on equity stabilized for retail banks after 2009. Meanwhile, earnings have remained volatile for both trading and wholesale banks. Moreover, as the authors note, "trading banks as a group show the highest volatility of [return on equity] across the three groups, swinging repeatedly between the top and bottom of the relative ranking."
And the same was true for efficiency. Over the period examined, trading banks were far and away the least efficient, with an efficiency ratio for the group generally hovering around 70%, while retail and wholesale banks had ratios around 60% over the entire period examined (as a side note, the figure in the chart above relates to 2013 alone). What explains the difference? According to the authors, "A possible explanation can be found in staff remuneration rates" -- in other words, traders are overpaid.
With these points in mind, it should come as no surprise that banks with trading operations are rewarded with lower valuations by investors. According to the latest figures examined by the report's authors, wholesale banks sold for roughly 1.3 times book value, retail banks for approximately 0.9 times book, and trading banks for just over half of book value. Suffice it to say, this is a powerful indictment of the trading bank business model.
Why trading weighs on profitability and value
If you've been paying attention to the news over the last few years, it isn't difficult to understand why the ostensible benefits of trading have proved elusive at most banks. In the first case, trading carries with it the potential for catastrophic losses. Two years ago, JPMorgan Chase lost $6.2 billion in the now-infamous "London Whale" debacle, which consisted of a wrong-way bet on the direction of derivatives tied to the value of corporate bonds. Two years before that, Switzerland-based UBS lost $2.3 billion thanks to a bad bet on exchange-traded funds. And two years before that, both Merrill Lynch and Morgan Stanley came within a hair's breadth of failure thanks to derivative trades tied to the subprime mortgage market.
No single story illustrates the existential harm posed by trading better than Barings Bank. For hundreds of years Barings, along with the House of Rothschild, was nothing short of European royalty. Barings bankrolled the Louisiana Purchase, financed France's indemnity payments after Napoleon's defeat at Waterloo, and provided the funds for Ireland to import corn during the 1845-1852 potato famine. Yet despite its power, prestige, and centuries-old reputation for prudence, Barings collapsed in 1995 after a single trader bet the bank on futures contracts tied to Japanese equity prices.
Even without those multibillion-dollar losses, however, trading has proved to be costly for the biggest banks. Earlier this year, six American and European banks were fined $4.3 billion to settle allegations that traders employed by them spent years manipulating the foreign-exchange market. In 2012 and 2013, traders at nearly a dozen universal lenders were caught manipulating the London interbank offered rate, a key interest rate benchmark for an estimated $800 trillion in securities and loans. And before that, JPMorgan Chase and Bank of America, among others, were assessed hefty penalties for rigging energy and municipal bond markets.
To make matters worse, moreover, there's reason to believe that the trading mind-set, in which everyone is an adversary, has eroded any semblance of duty that bankers on the retail side of these operations feel toward their clients -- I discussed this point, including the following quote, at length in an earlier article. The "root of the problem," says Richard Marin, former head of Bear Stearns' asset management division, is arrogance: "When you become arrogant, in a trading sense, you begin to think that everybody's a counterparty, not a customer, not a client ... [and] as a counterparty, you're allowed to rip their face off."
When will the coast be clear?
At the end of the day, there's no question that the regulatory pendulum will swing back into the bank industry's favor at some point over the next few years, bringing along with it a break from the onerous and seemingly annual multibillion-dollar fines triggered by illicit trading. But this shouldn't be interpreted by investors as a sign that the universal banking behemoths with active trading operations -- namely, JPMorgan Chase, Bank of America, and Citigroup -- will be transformed into prudent investments.
Nothing could be further from the truth. As Barings Bank and a whole host of other now-defunct financial firms have proven over the years, trading is to banking like oil is to water. No matter how hard the executives at these companies try to convince us otherwise, these activities just don't go together.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America, Citigroup, and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.