Friday, 26 September 2008

Learning from Rudi Bogni: The Thin Space of Financial Activity

Every good morality tale needs heroes as well as villains. In the past few weeks all we’ve seen are the villains raping and pillaging and despoiling all that we hold dear – rather like the first hour of the original and uncensored Mad Max.

I’ve made it pretty clear what I think about the villains that have got us into the current meltdown mess. Even I need a break from cynicism every now and then, however, to remind myself that better is truly possible. I thought I would take the opportunity of my post this week to reflect on a personal hero who epitomises what banking once was and whose philosophical writings can point us toward what banking should be again when the dust settles and we contemplate rebuilding our collapsed financial house of cards.

No one is perfect, and I’m sure he’s not either, but he’s shown consistently good judgement, intellectual curiosity and resistance to orthodoxy over the years. If we had a hundred bankers in the world like him, we wouldn’t have today’s crisis.

The bravest decision he took was in 1995, following the collapse of Barings Bank, as he explained in The Prospect:

I am a 47-year-old banker - chief executive of Swiss Bank Corporation in London, to be precise - and I have just decided that I need to go back to university for two years to study mathematics. Some of my friends think I am mad, and perhaps they are right. But perhaps something strange has happened to banking too.

It is hard to imagine that there is anything really new in banking. The tools of the trade have been around and in use, pretty much unchanged, for hundreds of years. Yet within the span of my own career, the world of international finance has enjoyed a renaissance-a spurt of creativity in the 1970s and 1980s, when new techniques emerged which have transformed the conduct of many banks and bankers. These techniques-collectively known as derivatives-have spawned a new jargon (would you know what to do with a Jellyroll, or an Alligator Spread?), huge new sources of profit, and mystifying new types of risk.

Imagine devoting yourself to the study of advanced mathematics in your mid-40s from the lofty heights of CEO of a Swiss bank! I wouldn’t be so noble, from more modest altitudes.

SBC had acquired O’Connor Associates, a Chicago derivatives trading partnership. The O’Connor partners were soon installed as senior executives throughout SBC, and changed it from a sleepy private bank to a powerhouse of aggressive power trading in the newly emergent global derivatives markets. Rudi needed to go back to school to know the business he was managing. He stepped down from the top job and got a degree in advanced mathematics at Imperial College, London.

That made Rudi an instant legend in the City and was the first I heard of him. He returned to finance as the Chief Executive of UBS Private Bank and Member of the UBS Group Executive Board. Since then I have followed his writings. For some years past I have enjoyed his friendship.

One year into the course, he emphasised again the importance of executives confronting the changing requirements of banking:

IC Reporter (10 February 1997)

Despite holding a degree in economics and business administration, Mr Bogni really did go back to basics under the tutelage of the Centre, sitting mock GCSEs and A levels in maths and statistics. Probability theory, calculus, algebra and stochastical modelling are also on the programme. “It’s a course not really designed towards a degree,” said Mr Bogni, “but towards the specific mathematics required for my type of business.”

Not all of those who share Mr Bogni’s business of derivatives are convinced of the benefits to be gained from the study of modern applied mathematics. However Mr Bogni believes that those who do not recognise its importance are avoiding the changing nature of financial markets. “Among the people that I respect there is a genuine understanding of what the issues are. It’s not a question of derivatives being a part of the financial markets, they are the financial market now.”

Rudi Bogni wasn’t afraid to admit that his bank had become unmanageable within the limits of his traditional banking background and understanding, and to take a hard look at his own qualifications to wager the bank’s capital on derivatives. If more CEOs had done that, then the proprietary dealing desks would never have gained the leverage that leaves the banking system so woefully undercapitalised today. If more CEOs pondered the philosophical basis for creating and allocating wealth, and the political means of asserting or coercing state power in the cause of more wealth accretion, then perhaps the destruction of jobs, savings and security would be less threatening to the investors, pensioners and taxpayers facing systemic financial failure this week.

In June of this year, Rudi published a piece in Wilmott Magazine (subscription only – the most expensive monthly on either side of the Atlantic, according to Forbes). At the risk of stretching fair use, and with the author’s consent, I’m going to quote it extensively here as it gets to the heart of the crisis we now face:

The Thin Space of Financial Activity

Those of you who may have read Bill Bryson’s A Short History of NearlyEverything will certainly recall his thesis that life on earth as we know it is an exceptional event and a possibility that materialized only within very small boundaries.

I wish you to consider how much smaller those boundaries are for the existence of financial activity.

First of all, you need a thinking species that lives and prospers in a cooperative environment. Second, you need a reasonably developed economy. Third, you need the ability to save and do more than survive only hand-to-mouth on a daily basis. Finally, you need reciprocal trust and a framework of law, as well as accepted customs and rules.

. . .

We have just witnessed last year—and we are still witnessing this year—how a relatively minor breakdown in trust and information has brought two markets, the interbank money market and the CDO market, to either display strong anomalies or freeze. Worse could come if we do not all learn to respect the boundaries within which financial activity can exist and thrive.

Investment bankers have to learn that if you have ambitions to act as an agent for an issue of a financial product, you should also have the means to make a market in that very same product in good and bad times—and investors should hold you to that. Regulatory walls between origination and trading have solved some problems, but they have also become an easy alibi for not standing behind one’s responsibilities.

Furthermore, they must understand that a revaluation of financial assets because the cost of capital has sharply decreased is not due to their genius. It is a physical law as much as conservation of energy, and therefore they do not deserve bonus payments for that. They should also realize that when they push bonus expectations beyond the moral threshold of 50/55 percent of net revenue, they are forcing their employers to take unacceptable risks to meet such expectations and that such a course of action can only end in tears.

Rating agencies have to learn about financial history and free thinking, not only about ticking boxes. Furthermore, they have to learn that the theory of overcollateralization differs from the historical experience, if you dig long enough into the past.

Regulators must learn that any new rule is a starting point for regulatory arbitrage and the mother of unintended consequences. Hence, there should be a few good rules, not thousands aimed at covering each potential circumstance. Most governments seem to have understood the lesson that the pursuit of inflation as an easy solution will bring them down in due course and for a long period. They seem to be deaf, however, to the fact that corporate taxation above 30 percent and personal direct taxation

over 40 percent, as well as an overall tax take including indirect taxation of over 50 percent, will either cripple both financial and economic activity, force people to take excessive risks, or push them elsewhere.

Retailers of financial products and solutions must realize that they are dealing with people’s lives and families’ futures. They cannot behave as street peddlers. Clear ethical boundaries must be the first line of defense, even before any legal framework is considered, because the law is unlikely to be as clear-cut as morality.

Finally, investors must be realistic about expectations. The best you can hope through financial activity is to preserve your wealth. If you want to create it, become an entrepreneur. If you want to gamble, stop whining when you lose.

If we do not all learn to be guided by such simple principles, financial activity as we know and need it will be put at risk. Trust will be eroded, impossible expectations will be created, and we will look back to the past 60 years as a golden age of economic development and financial maturity that may not be replicated any longer.

. . .

Politicians and regulators must stop hectoring and accept responsibility for having unintentionally pushed financial activity beyond sound boundaries by meddling without really understanding. Basel 2 in particular requires a very critical new look, if not a recall, as you would do for a line of cars when you realize that the brakes do not work as expected.

. . .

An excess of CO2 may be a major threat to civilized life as we know it, but the malfunctioning or freezing of the financial system could happen much faster, and we would have no control over it, as it depends on the psychology of literally billions of individuals. The consequences of such a malfunctioning do not bear thinking: breakdown in trade and investments, freezing of savings and pensions, advent of totalitarian regimes, war, and so on.

The financial system is a delicate mechanism and an essential one. Let us all treat it with some respect.

The thin space of financial activity requires a carefully calibrated commitment to balance by all parties participating in defining the sphere and scope and framework for financial interaction. In trying to deliver ever-increasing profits all around by growing the pie with inflationary monetary policies, executive excess, heightened investor expectations, regulatory and rating agency forbearance and other unrealistic and unsustainable policies, we have each and every one of us contributed to the current collapse.

Soon we will be doing a forensic analysis of what went wrong, and then look to craft new policies as a basis for rebuilding. We could do worse than look to Rudi Bogni’s analysis of the thin space of financial activity as providing the template.


More excerpts from Rudi’s writing over the years:

Re: Excessive Liquidity, Self-Indulgence and Self-Deceit (1 March 2007)

I read Dr Malmgren’s submission to ATCA with great interest. As in the Middle Ages and early Renaissance, there is an increasing risk in our less and less enlightened and less and less educated societies for the financial operators to be blamed for all economic evils, the same way that unfortunately the Jewish and Lombard bankers used to be blamed for the disasters caused by the excessive indebtedness of the European monarchies of the time.

Reality is much simpler. Take a bathtub and fill it to 1/3, then throw a stone into it. It may cause waves, but it might not flow over. Take the same bathtub and fill it to the brim, then throw a stone into it. It is most likely to flow over.

What we are experiencing is an unusually long period of extreme liquidity. Whatever the motivations for it, they are essentially political motivations, driven by political intents. Whether it is to finance wars without increasing taxation, whether it is to make people feel good about the inflated value of their assets so that they are going to spend more and promote GDP growth, whether it is to buffer one country’s voters from the natural effects that working less should entitle them to a lesser share of global goods and services, there are political intents behind the excessive liquidity.

Politicians are shying away from telling the truth to their voters and a vicious circle of self-indulgence and self-deceit is being buttressed by excessive liquidity.

Blaming incorrectly the equivalents of the Jews and Lombards of today, ie hedge funds and private equity investors, is the modern version of the French kings locking up the bankers in order to avoid taking the due blame and repaying the debts.

Long term it is a strategy which can ultimately lead only to decline.

Turning difficult issues which require courage, like global warming or global competition, into a religion of fear is the novel way by which politicians aim and unfortunately short-term succeed in keeping the masses, and often even the intelligentsia, in the dark and unable to confront policy-makers on the rightful field of rationality.

Rudi Bogni

The Left and Right defined the 20th century. What’s Next? Prospect (March 2007):

Left vs Right was and is purely a nominal distinction between two strands of the same totalitarian posture. The real problem of the 20th century was that the demographic and economic pressures that fractured the empires gave rise to national states with leaderships ill equipped to face the nihilist challenge. The vacuum was filled by totalitarian regimes, whose ideologies set fire to Europe and the world. Remember that Hitler was a failed architected, Staline had studied for the priesthood an Mussolini was a schoolteacher. The heirs of the 19th and 20th century nihilists are today’s faith-based terrorists. If today’s democracies fail to win against the new nihilists on the intellectual and communication level, they will have no chance to win in the security space and will create another dangerous vacuum, ready to be filled. Nation states have proven a disastrous political experiment in the 19th and 20th century; they may well prove catastrophic in the 21st century, due to nuclear proliferation. Nevertheless, I hope that the 21st century will see a substantial reduction of political infrastructures. If a conglomerate is bad or indifferent at most of what it does, shareholders force it back to its core competences. Everything else has got to go. Why should it be different for governments? This is neither left nor right; it is common sense. Large countries’ politicians love to deride small countries’ direct democracies. Why? Because they fear their example and their nimbleness. The political systems inherited from the 20th century, whether democratic or totalitarian, are neo-feudal, incompatible with a 21st century when electors vote every so many years, but consumers vote and bloggers blog 24/7.

The Stars and Gripes (12 July 2002):

Curing hatred of America is not easy. The European intelligentsia, because of the value its educational system places on knowledge for its own sake, tends to develop a highly critical sense and a healthy scepticism. US elites, despite being trained to think for themselves, tend to be less self-critical, perhaps too focused on getting rich. This creates a big communication gap. I concentrate on Europe versus America because if there is anybody who can help America to shed its self-satisfied myths and treat the rest of the world as equals with whom it is OK to disagree, it is us Europeans. US and European interests often converge, even when our hearts and minds do not meet.

What is certain is that half-educated people, with puerile, dogmatic, self-centred half-knowledge, are the salt of tyranny. The greatest tyrants of the century we have just survived, Hitler and Stalin, were half-educated men of hatred. Only knowledge accompanied by self-deprecating critical spirit can dispose of hatred, whether of America or of the rest of the world.

But I must admit - and this is why this book created a sense of emotional release - that until now I have never seriously confronted my close American friends with what I did not like about their country. I used the same polite diplomacy to avoid taking to task my Jewish and Arab friends over Palestine. This is wrong. Discourse is the stuff of civilised life; complacency is the crystallisation of ignorance and the begetter of lost lives.

Raised by the Yankee Game (3 May 2002)

When I hear the debate as to whether capitalism won over communism, triggering perhaps the end of history, I get very annoyed. Capitalism did not win a thing. Thatcher and Reagan may have pushed down communism’s crumbling walls, but the revolution was elsewhere. It was in places such as the City of London, beacons of freedom, where young men and women of any nationality could go to work every day reporting to a person of different background and culture, working for shareholders perhaps of a different country, free to choose their career, employer, lifestyle, perhaps even work attire. Free to speak their mind and to pay the price for it if necessary. But what a small price in comparison to that of living in an autocratic society such as the Soviet Union.


OkieLawyer said...


I am going to take issue with something he said:

They seem to be deaf, however, to the fact that corporate taxation above 30 percent and personal direct taxation over 40 percent, as well as an overall tax take including indirect taxation of over 50 percent, will either cripple both financial and economic activity, force people to take excessive risks, or push them elsewhere.

Excessive risks are being taken here in the U.S. and the tax rates are far below that (highest income tax rate is 38%, corporate tax rate is below 30% and overall tax rate is below 50%). So I would dispute that there is such a relationship. Not only that, but the Scandinavian countries have much higher tax rates, but I don't hear about people having to take excessive risks there.

Colin said...

Simply; thanks for this.

I'm reminded yet again why I read this blog every time my RSS informs me that there's a new post.

Moreover, what was formerly periodic reading has given way to something more focused, because the comments from your readership (the greater majority of whom appear to be many furlongs ahead of me in knowledge) are often equally illuminating. Thus oddly, I find myself parsing the comments too, which is also a "first"!

I've learned a lot from reading your posts, and also learned how little I know, which is a wonderful lesson in itself. That realization has caused a mini-pilgrimage to the fountains of orthodox theory.

So..."thanks for this" - really.

London Banker said...

@ okielawyer
If that's your only criticism after all that text, then Rudi's holding his own just fine. And I agree your point, by the way.

@ Colin
It seems superfluous for me to shout "panic" when everyone else already is. Today I hoped to whisper "hope".

vikas said...

Wow, Thanks for this introduction.
Though I cannot help but think repeatedly of Brecht's poem, it is good to know that there is some common sense at the heights of the financial world.

Teach contentment.
Those for whom the contribution is destined
Demand sacrifice.
Those who eat their fill speak to the hungry
Of wonderful times to come.
Those who lead the country into the abyss
Call ruling too difficult
For ordinary men.

yoyomo said...

I think value for money is what most determines attitudes toward taxation among the majority of citizens (the rich will always oppose any level of govt taxation as they aren't dependent on any of its services).

In Scandanavia high taxes are invested in the welfare of the population and so they support that level of taxation. In the US taxes are squandered on imperial projects and debt service payments to the wealthy and foriegners for previous imperial projects which don't benefit the population and so they resent even low levels of taxation.

An exception would be SocSec. Since people expect to get that money back, few complain about it as much as the income tax which they feel doesn't benefit them directly even if they contradictively support ever larger Pentagon budgets.

Knute Rife said...

I agree. The tax-rate kvetch is Quatsch. Most US speculation is occurring at our obscenely low capital gains rate.

Bogni saw not merely that he was ignorant but that he had no way of determining what he was ignorant about. That problem is now systemic, and pej's black swan comments point this up. What good is a Gaussian curve in a system that is all spikes? If you don't know how Gaussian curves work, how can you tell what they're telling you? If you don't know where your ignorance starts, how do you know where the Barn Stuff starts? At least Bogni has attempted to take up arms against the problem.

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Thai said...

Wonderful posting. Would you agree that at its heart, it has a very platonic ideal? (I agree with it by the way).

I also agree with Okie and yoyomo and you that taxes are an illusion and that the real issues is and always have been attitudes towards money which I would sum up as: trust, cooperation and consequence.

A very smart blog titled Sudden Debt has taught me that money is really debt. And I have always known that debt is really trust-cooperation-consequence.

But I tend to look at the origin of what we are now experiencing as having at least some roots in the double edge sword of America's greatest strength and greatest weakness- our core embracement of diversity as our top national priority.

For if you think about it, really from our inception, America developed a system to protect the individuality and autonomy of different groups within a much larger culture (I am sure that Okielawyer and Knute could explain this much better than I). And while it is definitely true that this original vision was corrupted at inception with a kind of "original sin", still our template's basic structure has allowed America to maintain, incorporate and indeed allow to grow a VERY diverse mixture of cultures and nationalities with a degree of social harmony unique (imo) for a nation of 300 million people (which is FYI why I compared our Gini with ALL of Europe).

But our system, which protects and encourages cultural diversity, also makes cooperation on THE MOST DIFFICULT issue of all- rationing- all the more difficult.

For the reality is rationing and prioritization are simple facts of life. Every culture in the world must ration if it is to survive. And in even the most homogeneous cultures, rationing discussions are contentious. Yet at least as we ration according to our culture, it is MUCH easier to get agreement when our cultures and values are similar.

Now think how hard these discussions are when our cultures are not alike (I think it no accident that many of the areas where America spends the most on healthcare are precisely the areas where cultural and language differences are also the greatest vs. the "american benchmark" (whatever that is).

Different groups ration differently, they ration according to their cultural values, they ration according to their socioeconomic experiences.

And then add how much harder it is for Americans to get agreement on rationing when the cultural differences ALSO are significantly different socioeconomically?

Do I spend my money keeping my parents alive in a retirement a little longer with some reasonable quality of life? Do I try to shrink the classroom size of my children instead? Do I try to develop alternate energy systems?

And if I have no children or parents, and I am asked to keep someone else's ailing parents alive and instead have less to enjoy my own retirement, how do I do this when I do not approve of the attitudes towards saving and money that I see in that "other culture"? Or if I am asked to shrink the classroom size of someone else's children and again I do not approve of the spending or education choices I see being made by that "other" culture, how am I to react?

And what if one culture has not experienced longevity to the same degree as a second culture, adjacent culture? Why would I continue to save for something that I do not understand having no experience reference?

And what happens if the average life expectancy of this first culture suddenly increases?

On these issues (which are really attitudes about money, attitudes about trust-cooperation and consequences) I think yoyomo is right.

I do not share the conspiratorial views expressed in some of your other postings or by some of your other commenters, but I do think America has a real problem in front of it. We have a reverse engineering issue that is not easy to overcome at all and which I think (without in any way sounding critical) europeans were simply lucky to solve at a time when their cultures were far more homogeneous than they are today.

I do not have a solution to this issue for America, and I ration according to my own values, and if it is not clear, I love our 'fruit salad' model of diversity.

I guess the most optimistic thing I can add to this post is I am hopeful Obama can figure a way to bridge this divide.

dink said...

"it depends on the psychology of literally billions of individuals"

I like your philosophical friend Bogni; he recognizes that trust is fragile. And that civilization is based on trust.

I hate to be the slowest one in class, but what would result from an illiquid Federal Reserve Bank? To be honest, until about six months ago I thought the Fed was a government institution. And since they are actually a private company, how do we know what their assets and liabilities actually are since they don't have to report to shareholders?

Sorry for the questions, but I am genuinely curious. Thanks for taking the time to create such an informative blog.

Peter J. Bolton said...

People develop culture through food and family; politicians make claim to advances of the people, who advance despite the body politic; and politicians always project blame away from themselves.

I feel the purpose of our suffering under the treasonous and cowardly acts and rules of politicians, is for society, at the individual level, to learn his / her lessons to outgrow the need of these parasites and feral.

Bottom line: Politicians need the peoples whereas the peoples have NO need of the politicians.

Freedom is naught but minding your own business and keeping your hands to yourself.

Please note that I have never known one politician who is capable of the above.

Ho hum


yoyomo said...

I'm no banker but the way I understand it is that the Fed has its own set of rules by which it must legally abide; it's not totally free to do as it pleases.

The most important rule that the Fed must observe is that all the money it conjures into existence must be backed by collateral of specified quality, mostly Treasury debt. If the Fed's supply of existing money runs low or the quality of its collateral deteriorates then it is considered illiquid and its only recourse is to create new money to purchase fresh collateral (expand the balance sheet i.e. money supply).

This is considered highly inflationary and is watched very closely by the bond market and can trigger a run on the dollar by foreign investors. When the Fed finds itself in this box it is the first step on the road to Zimbabwe if it resorts to printing or a deflationary collapse if it can't borrow the funds it needs to finance its interventions. This is why the bailout efforts are being shifted to the Treasury to prevent the Fed from going broke. I'm sure LB can expand on or correct any info in need of such.

dink said...

Thanks Yoyomo.

The more secretive the organization, the more prone to conspiracy talk it becomes. I think these central banks would be doing themselves a favor to allow more transparency.