MF Global is the Final Nail in the Principal Banking Coffin
The MF Global collapse provides an important lesson concerning the effectiveness of the principal or proprietary banking model.
Leading up to the financial crisis, principal banking had replaced slow-growing, client-focused agency banking as the dominant model for large banks. Institutions focused on executing transactions as principals for their own accounts instead of for their clients.
Jon Corzine pioneered this transformation while heading Goldman Sachs in the 1990s. Goldman's apparent success, reflected in stellar returns on equity, lead to envy and imitation that became ruinous to competitors during the 2008-2009 financial crisis. Institutions are now running from Goldman with its single digit ROE and depressed stock price, which trades at a discount to book value.
Corzine attempted to repeat the successful application of principal based banking upon assuming leadership of MF Global in March, 2010. He downplayed its agency business, and utilizing a relatively clean balance sheet he placed large leveraged sovereign debt bets. Unfortunately for Corzine, this is not the 1990s. As James Grant notes, sovereign debt has gone from providing a risk free return to becoming a return free risk. These actions caused MF Global's failure 19 months after Corzine's arrival as declining debt values triggered fatal collateral calls.
Strategies wax and wane depending on their economic environment. Principal banking is a product of "the great moderation" which began in the early 1990s and ended in 2008. Credit costs fell during this long period of unusual economic stability. Cheap credit fueled asset price increases and triggered large trading profits. Banks began generating more profits from principal activities than from customers.
At times banks' interests appeared to conflict with clients'. The choice became one of, as the joke goes, "being a winner or a customer," as conflicts were rationalized as synergies.
Unfortunately, principal banking had few principles as was discovered during Congressional crisis investigations. Goldman's disclosure that in 2007 it was simultaneously shorting/selling the same securities it was recommending to investors is a classic example of the problems with this model.
Principal banking is essentially an asset-intensive carry trade. A profit is earned by holding an asset provided the holding period return exceeds the holding or carrying cost. This requires a rising market to thrive. Asset prices fell once credit costs rose during the crisis and the strategy collapsed.
Principal bankers, including Corzine, failed to consider that their returns were risk not skill related. Hence, they ignored, rather than managed the inherent risk of asset-heavy principal banking by focusing on ROE unadjusted for risk. They utilized just-in-time risk management that recognized risk only when it surfaced. This led to the failure or near failure of the top 10 principal banks during the crisis. These banks survived based on the Federal Reserve loan program (the magnitude of which was just recently revealed).
MF Global's failure should represent the final nail in the principal banking model coffin. The end of the great moderation hits at the core of the carry trade. Static or falling asset prices cannot support balance sheet intensive principal banking. This is further complicated by regulatory developments like the Volcker Rule and higher risk-weighted capital requirements.
Finally, investors have soured on the model. This is reflected in the book value discounts at remaining principal banking institutions including J.P. Morgan Chase, Jefferies, and Morgan Stanley among others. Such institutions are built to crash and dependent on continued Central Bank support for long-term survival. This support may become increasingly problematic going forward a given a more hostile political climate.
Principal banking may continue to linger in the short-term despite these facts. The great moderation favored banking executives with trading backgrounds. Thus, many large institutions continue to be run by traders despite their mixed success. These executives may fall back on old habits, as did Corzine, and gamble for redemption to cover performance problems. Many of these executives are anchored in the past and need to be replaced. They are unable to make the necessary changes to adapt to the new market. Boards must review not only new strategies and business models, but also their senior managers tasked with implementing them to avoid another MF Global.
Big banks need to move on. The replacement model may well be a return to agency banking, with its focus on executing client transactions instead of speculating on asset prices. This smaller utility type banking may seem boring, nonetheless, investors and regulators may have had all the excitement they can stand from principal banking. Perhaps, that is the real lesson of MF Global.
Joseph V. Rizzi is a senior strategist at CapGen Financial Group, a private-equity firm. He spent 24 years at ABN Amro Group and LaSalle Bank.