Maybe banks should operate like casinos

"Bart Naylor" "Financial policy"Wall Street’s attention on Washington currently centers on the Volcker Rule, a brief but ballistic section of the Dodd-Frank Wall Street Reform act often characterized as ending casino-like practices by taxpayer-backed banks. The law forbids proprietary trading, or speculating for the bank’s own benefit. Heads, the bank wins for its shareholders and its highly paid traders; tails, the taxpayers pay off the losses.

But to denigrate American banks by likening them to casinos may be inaccurate and unfair—to the casinos.

Casino’s churn out money from slots geared to take in more quarters than they pay out. Even in the high stakes tables, a casino enforces limits, guarding against the possibility that one gambler could break the house. Bets themselves are capped. At a ‘high rolling” black jack table, such as at Caesar’s Palace, gamblers can place bets of no more than $50,000, the so-called table limit. Further, spotters watch from above for sharks using illegal counting techniques at black jack. In fact, the most significant “risk” factors about which Caesars warns shareholders are competition from the rival casino down the street, the economy, and its pension plan. As Jim Ensign, the former Nevada senator once said, “In Las Vegas, most people know that the odds are stacked against them. On Wall Street they manipulate the odds while you’re playing the game.”And finally,

Las Vegas casinos have never begged Americans for a bailout because some MIT geniuses figured out how to game the black jack table.

In contrast to casinos, American banks and their Washington regulators didn’t properly prepare for the the risks that savaged the financial sector and the global economy three years ago. Former Federal Reserve Chairman Alan Greenspan claimed no government agency—not even the industry—could detect the major risk of such major problems as a bubble. “History tells us they cannot identify the timing of a crisis, or anticipate exactly where it will be located or how large the losses and spillovers will be,” he testified before Congress. Whether or not that’s true, it seems clear neither the agencies nor the collective industry prepared.

The closest banks come to “table limits” is through the measurement of Value at Risk, a statistical model. A VaR model estimates a range of possibilities and spits out a dollar figure that it is fairly confident it won’t lose more than once in a hundred days. This proved an insufficient safeguard. As Joe Nocera of the New York Times observed, “The fact that you are not likely to lose more than a certain amount 99 percent of the time tells you absolutely nothing about what could happen the other 1 percent of the time. You could lose $51 million instead of $50 million — no big deal. That happens two or three times a year, and no one blinks an eye. You could also lose billions and go out of business. VaR has no way of measuring which it will be.”

Based on market trading history leading to October 19, 1987, VaR would have placed the odds that an investor would lose more than 22 percent in an equity portfolio that day were less than one in seven trillion—more than the age of the universe. And yet it happened.

Moreover, critics assert that current VaR can be gamed. Since the magnitude of VaR determines regulatory capital requirements, or how much the firm must pledge its own money to speculate, firms may be motived to generate a low number, or to generate a number based on figures that don’t encompass the full history of the banks. While VaR means that each bank generates a single number, the model that generates that number is unique to each bank.

Even assuming no games, VaR seems to invite risk-taking. Hedge fund manager David Einhorn claims VaR can be “potentially catastrophic when its use creates a false sense of security among senior managers and watchdogs.” The odds may be miniscule for a person being killed in a car accident on any given day. But that shouldn’t relieve a responsible driver from wearing a seatbelt, observing the speed limit, and eschewing alcohol. VaR proved it was not a radar gun capable of identifying financial speeders. VaR may have been that miniscule probability that relaxed bankers from the necessary fear of loss.

Step back. George Bailey’s bank (from “It’s a Wonderful Life”) extended mortgage loans to the good folks of Bedford Falls based on their income, the value of the house, prospects for the future. The bank set aside some reserves in case a borrower fell behind in payments. Today’s banks now make short term bets with complex mathematical model based on whatever historical data that may be convenient to escape tough capital rules. What’s needed are higher capital requirements. If banks take risky positions, they should do it with their own money, or at least more of their own money—and less borrowed money the taxpayer might need to repay in the event of a bad bet. There should be table limits; and the limits should be un-gameable and not encourage excessive risk taking.

Banks should operate more like a casino.

Bartlett Naylor is Public Citizen’s financial policy advocate.