Three Reforms Even the Loudest Banking Critics Should Applaud

Wall Street hawks hungry for more aggressive reforms following the crisis should avoid letting the perfect be the enemy of the good.

What do I mean? Toward the end of the just-released movie "The Big Short," the narrator recites a list of post-crisis developments — sure to be the wish list of any industry critic — that in fact haven't happened. They include the arrests of multiple leading players involved in the 2008 meltdown, and a breakup of the biggest banks. Indeed outspoken progressives seem to give flunking grades to the industry's post-crisis response efforts as they push for more drastic reforms.

But focusing too heavily on what has not happened ignores the positive changes in industry practices that have taken place since the crisis. It is worthwhile to summarize them.

More Cautious Traders

First, there has been a cultural shift at the major banks away from short-term risk-taking. Examples of this include the fact that traders' trading limits are managed more carefully and comprehensively by market risk officers. Firms have also reduced incentives for traders to take long-term risks for short-term gains. Bonus payments are held back or other punitive actions are taken when traders have been found to have exceeded their trading limits or gone outside of their trading mandate.

Since the "Big Short" era, a more aggressive risk officer has come to the fore, one who has a seat at the table when new trades are being discussed. The risk officer's opinion is treated more seriously by trading operations executives operating under the assumption that that short-term gain is not the only factor in deciding whether to move forward with a trade. Furthermore, officers focused on risk modeling have put in place important industry strength controls that have been able to provide more transparency around new trades, model changes and complex trading activities.

In fact, perhaps the clearest sign of a shift away from risky trading is that more than a few traders — complaining of bureaucracy and compliance overreach — have left to go to work for hedge funds, organizations perhaps more perfectly designed to take on extreme trading risks.

Regulations with Actual Bite

Second, regulatory changes have begun to have a noticeably positive effect. The Basel III regime has led to significant deleveraging by U.S. and European banks and this has taken some important elements of high risk out of the equation. Regulators have a much better view into the liquidity positions of their regulated entities through the Federal Reserve's Comprehensive Capital Analysis and Review and other stress test measures, deploying their own conservative models into the risk assessment process.

Significant new disciplines around data management and data governance driven by Dodd-Frank Act requirements point to a greater certainty and understanding of a bank's true positions and risk exposures. The Volcker Rule is having a clearly visible impact. The role of investment banks in trading capital has been reduced. Banks that had aggressively invested in hedge funds and proprietary trading desks have closed down those desks, restricting all prop trading activity. Swap transactions that used to take place only bilaterally — a risky proposition that had disastrous effects in the crisis — are now moving to exchanges as required by the 2010 reform law.

A Shift Toward Advisory Services

Third, the business strategy of leading investment banks has changed. One good example is Morgan Stanley, which for several years now has explicitly focused on increasing the proportion of its revenues from stable sources, most particularly wealth management and institutional trading services. This strategy has borne fruit, exemplified by the successful integration of Smith Barney, of which Morgan Stanley purchased a majority stake from Citigroup

A more prudent strategy is also demonstrated by increased revenue from commission-based trading activity; the level of capital assigned to profit-making from complex trading activity has been reduced. This was reinforced by the organizational announcements made in the last week.

The narrator in "The Big Short" was not too optimistic for the future and our ability to prevent a reoccurrence of the events of 2008. But the changes I have outlined above represent a pretty good defense against a repeat of the financial crisis.

Sure, a different scenario could emerge to trigger a future crisis. One concern often expressed in the post-Dodd-Frank era is that the huge emphasis on decisions needing documentation, verification and validation from multiple control layers is diverting too much time and resources away from actual risk management and professional judgment. Ideally, banks and regulators can find the appropriate balance of risk management and business innovation to limit the likelihood or effects of such a scenario going forward.

Andrew Waxman is an associate partner in IBM Global Business Services' financial markets risk and compliance practice and can be reached at abwaxman@us.ibm.com or on Twitter @abwaxman. The views expressed here are his own.