The head of UBS recently told a UK parliamentary panel that UBS would “no longer put integrity above profits.” The problem with this statement is that it almost sounds like a choice of one versus the other. Common business sense says that if we act with integrity, then we have a long term sustainable business. We also know that if we drop integrity, that we can possibly have larger profits over the short term but we may no longer have a business to run in the long term. So to some extent, this is a business strategy decision based on a time horizon. Are bankers focused on the short term or the long term and what do those terms mean in the banking world? If we look at the trading floor and the specific activity of providing liquidity to clients, the conflict of interest between long and short term thinking becomes very clear.
Recent history says that bankers on the trading floor were overwhelmingly focused on the short term and that time horizon was a few years or less. In fact the cases that are coming to light specifically point to a time horizon of a year or less because that was the bonus cycle. The profitability of each trade done in a year was the determinant of the bonus for the individuals responsible for executing the trade. There are a few points to make clear in order for the issue to make sense. First is that the profitability of a trade is not determined at the point the trade is hedged for the bank. It is determined at the point the trade is executed by comparing the executed price to the fair market value for that trade. Banks deserve to make profits when they provide a service clients, and thus if something has a fair market value of 10 and the bank sells it to the client for 10.5, then the bank has made a profit of 0.5. That makes sense only if the bank can actually buy the product at 10 in the first place which is not always the case. Regardless of whether the banks position is hedged or not, the 0.5 is declared the profit. Second there are many trades for which the profitability is not as simple as looking at the price differential between buying and selling the same product. This is for tailored transactions as well as many derivative trades. Thus the calculation of profitability is complicated and often subjective. This is where part of the conflict occurs. The person determining the profitability for the bank is often the person who is most incentivized to show a high profit.
When looking at this situation, it is important to note that there is often more than one individual responsible for the execution of the trade. The individual talking to the client is the sales person and the individual putting the price on the transaction is the trader. There should be a natural tension between these two individuals based on the sales person wanting to preserve the client relationship for a long time and the trader wanting to maximize profits and minimize risk. However the incentives and the internal cultural pressures at each institution can turn this tension on its head. What we clearly see in some cases coming to light is a scenario where both the sales person and the trader are looking to maximize profits and minimize risk to the bank to the detriment of the client. Hindsight is 20/20 and some of this can be explained by saying that many of the transactions done with clients were done when no one in the market had any idea how risky they were. It was boom time and crazy to think investing in investment grade credit for example could ever result in the losses we eventually saw.
Today, we should all be thinking about how to make business decisions in a commercial manner. The economic volatility we’ve now been living through for the past 5 years should have taught us that there is no better business strategy than a long term one. Why is it then, that it still feels like we have to explain that integrity and profits should go hand in hand rather than be adversarial?