'Lucy in the Sky with Diamonds'

By Walter Molano,  guest columnist

Penned more than 45 years ago, the psychedelic lyrics to 'Lucy in the Sky with Diamonds' written by John Lennon are quite adequate for the pair of diamonds who reside on the opposite shores of the Atlantic.

The travails of some of the most important investment bankers of the financial world confirms that these managers cannot rely on just traditional services, but they must resort to chicanery in order to generate the necessary revenues and conditions to survive.

Hailed as financial engineering, the development of derivative products were nothing more than a scheme to boost fees by weaving a thick veil of complexity. Greater competition and the deregulation of traditional financial services, such as equity and bond trading, reduced the commissions produced by these business lines.

As a result, the sector was forced to consolidate in order to generate the economies of scale needed to create a sustainable operation.

Managers were also induced to search for other types of transactions that would produce higher fees.

This led to a proliferation of new products, such as reverse convertibles, ETFs, CDOs and CDSs. Unfortunately, the introduction of these new products created a perverse set of incentives that only convinced bank operators that they needed even larger economies of scale.

The geometric expansion of financial institutions coincided with a prolonged period of lax monetary policy.

The accommodative stance of Fed chairmen Alan Greenspan and Ben Bernanke allowed banks to cheaply expand their balance sheets, while using accounting gimmicks to hide many of their liabilities.

In hindsight, this was an accident waiting to happen. The unbridled expansion of banks, the explosion of new financial products that were designed to obfuscate fees and the prolonged period of loose monetary policy created a toxic environment where the implosion of the financial system was inevitable.

Things came to a head in 2008, with the collapse of Bear Stearns and Lehman Brothers.

Excessive risk-taking

Faced with the imminent collapse of the US financial system, and most likely the rest of the global financial system, the Federal Reserve encouraged investment banks to pair up with traditional commercial banks or obtain banking licences, thus allowing them with unlimited access to the discount window.

If there was an unprecedented degree of scale in the financial industry prior to the onset of the global financial crisis, the situation became even worse. Titans became lumbering behemoths, whose only way to survive was by resorting to duplicitous activities, such as rigging the Libor market, or taking excessive risk.

Although regulators and politicians expressed horror at the 'cesspit', the paper trail shows that they were fully aware of what was going on.

They are not blind to the mechanics of the financial industry and the measures that must be taken in order to keep such giants afloat.

With traditional business lines hit by the global deleveraging process and reeling from an endless succession of shockwaves, the only way to keep such leviathans afloat is by resorting to heterodoxy.

The lurid behaviour of such large institutions is akin to watching a person undergoing to a very bad experience with psychotropic substances.

Unable to grow more, the only choices for these institutions are self-imposed downsizing or regulatory dismemberment. The former is a very difficult option, available only to the most mature and sober boards of directors.

Most managers still believe that we are undergoing a temporary adjustment of the business cycle, and we will be back to business in a very short time. They will avoid cutting too deep into the fat, with a fear that the cycle will suddenly shift and they will be caught unprepared for the resumption of business.

This is why the second option will be the most likely scenario. Either under the guise of a regulatory imposed spin-off of none-core business lines or under the direction of a bankruptcy judge, financial institutions will be forced to reduce their scales to a dimension that is commensurate with their ability to generate a stable stream of revenue in a risk-adjusted setting.

The reality is that the financial sector played its cards very well during the past two decades, allowing it to generate enormous wealth.

However, the sector has now been dealt a pair of diamonds, and it has to fold.

Therefore, it is time to clean itself up and forget about the girl with 'kaleidoscope eyes'.

Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC. wmolano@bcpsecurities.com