(Caijing.com.cn) My understanding of what's wrong with the banking system was clarified recently when I helped a Chinese company extricate itself from a bad deal. I'm an American lawyer who spent several years working in Hong Kong for major investment banks. In that capacity, I read correspondence between the company and its bank. I realized that the system's problems are not just about greedy salespeople, but that investment banks have quite often failed as institutions. My job was to write complicated derivatives often sold to Chinese companies. Today, many companies still don't understand how risky those products are. I fear derivatives contracts could cost these companies a lot of money before they expire. Like the American government, banks have different branches that are supposed to limit the powers of one another. On one side are salespeople and traders. The amount of money they earn depends on how much they generate for the bank. So it's in their interest to sell as many financial products as possible; the more complex and profitable, the better.
On the other side are the overseers -- lawyers, credit analysts and compliance officers. Their job is to protect the firm. An overseer is supposed to block reckless transactions at any bank known for selling dangerous products that could hurt its business. My position was somewhere in the middle: I was a "legal structurer," which means I was a banker with legal training, and I was often enlisted by salespeople to get derivatives approved. I learned the process from the inside. Right around the time banks started selling complicated derivatives in China about five years ago, the financial industry underwent a change that broke down the internal balance of power at banks. Bankers who earned simple fees by helping clients raise capital began working together with other bankers who sold derivatives. The 1999 repeal of the Glass-Steagall Act in the United States and similar liberalization worldwide let banks combine the two groups of bank services under one roof. But previously they had been kept separate – for good reason. This change is easy to understand with an example. Imagine a successful, newly listed Chinese company that needs capital to grow. Its bank first gauges interest among global investors. Let's say the bank decides the company could most efficiently raise money by selling corporate bonds in U.S. dollars. But the company, which earns revenue in yuan, would face the risk of changing currency values that could make debt repayments more difficult. So the bank might propose a hedge to remove this risk from the client, in exchange for some initial profits from the derivative.
All that seems normal; it's just packaging a bond with a hedge. But think about what happened behind the scenes. The arrangers of bonds and the sellers of derivatives got together to concoct a single solution. Even though these two types of bankers are generally allowed to work at the same firm, lawyers and compliance officers would still maintain a clear separation -- the so-called "Chinese wall" -- between them. Why? To prevent insider trading. Traditional bankers who arrange bonds are considered trusted advisers and hold private information about their clients. When derivative salespeople know what bond advisers know, they may be tempted to pursue unfair profits by using information about those clients to their advantage. Bank overseers were well aware of this danger. So they made sure that any salesperson with inside company information could not trade securities in that company, nor could he or she even speak about the company with anyone from the derivatives side of the aisle. Nevertheless, derivatives bankers designed products together with bond arrangers. The potential profits were too attractive not to. And derivatives bankers always had incentives to sell clients these transactions, whether or not bond arrangers thought companies needed them. I no longer work for investment banks, and I recently advised a Chinese manufacturer that was served by a single team of bankers, which included bond arrangers and derivatives experts. The client never knew that these two groups had different motives. Worse, the company signed an agreement that effectively locked it into working with the same bank for both its debt offering and any derivatives. Even after the debt offering fell apart in the global credit meltdown, the company still wound up with a currency swap that now threatens to wipe out its quarterly profits. Clients may have known about these conflicting roles, but such awareness would not have come easily. Contracts were complicated. See if you understand this contract language: The bank "may effect other transactions involving financial instruments related to the bond offering and other transactions contemplated herein." That means the bank might make money off a deal, whether or not its client does. But many Chinese companies didn't understand the implications of that kind of language, whether they read it in Chinese or English. And salespeople certainly didn't go out of their way to enlighten them. This conflict of interest has caught the attention of Chinese regulators. But the issue won't be resolved anytime soon. From now on, Chinese companies, especially those with derivatives already on their books, should watch for what really motivates their bankers.
On the other side are the overseers -- lawyers, credit analysts and compliance officers. Their job is to protect the firm. An overseer is supposed to block reckless transactions at any bank known for selling dangerous products that could hurt its business. My position was somewhere in the middle: I was a "legal structurer," which means I was a banker with legal training, and I was often enlisted by salespeople to get derivatives approved. I learned the process from the inside. Right around the time banks started selling complicated derivatives in China about five years ago, the financial industry underwent a change that broke down the internal balance of power at banks. Bankers who earned simple fees by helping clients raise capital began working together with other bankers who sold derivatives. The 1999 repeal of the Glass-Steagall Act in the United States and similar liberalization worldwide let banks combine the two groups of bank services under one roof. But previously they had been kept separate – for good reason. This change is easy to understand with an example. Imagine a successful, newly listed Chinese company that needs capital to grow. Its bank first gauges interest among global investors. Let's say the bank decides the company could most efficiently raise money by selling corporate bonds in U.S. dollars. But the company, which earns revenue in yuan, would face the risk of changing currency values that could make debt repayments more difficult. So the bank might propose a hedge to remove this risk from the client, in exchange for some initial profits from the derivative.
All that seems normal; it's just packaging a bond with a hedge. But think about what happened behind the scenes. The arrangers of bonds and the sellers of derivatives got together to concoct a single solution. Even though these two types of bankers are generally allowed to work at the same firm, lawyers and compliance officers would still maintain a clear separation -- the so-called "Chinese wall" -- between them. Why? To prevent insider trading. Traditional bankers who arrange bonds are considered trusted advisers and hold private information about their clients. When derivative salespeople know what bond advisers know, they may be tempted to pursue unfair profits by using information about those clients to their advantage. Bank overseers were well aware of this danger. So they made sure that any salesperson with inside company information could not trade securities in that company, nor could he or she even speak about the company with anyone from the derivatives side of the aisle. Nevertheless, derivatives bankers designed products together with bond arrangers. The potential profits were too attractive not to. And derivatives bankers always had incentives to sell clients these transactions, whether or not bond arrangers thought companies needed them. I no longer work for investment banks, and I recently advised a Chinese manufacturer that was served by a single team of bankers, which included bond arrangers and derivatives experts. The client never knew that these two groups had different motives. Worse, the company signed an agreement that effectively locked it into working with the same bank for both its debt offering and any derivatives. Even after the debt offering fell apart in the global credit meltdown, the company still wound up with a currency swap that now threatens to wipe out its quarterly profits. Clients may have known about these conflicting roles, but such awareness would not have come easily. Contracts were complicated. See if you understand this contract language: The bank "may effect other transactions involving financial instruments related to the bond offering and other transactions contemplated herein." That means the bank might make money off a deal, whether or not its client does. But many Chinese companies didn't understand the implications of that kind of language, whether they read it in Chinese or English. And salespeople certainly didn't go out of their way to enlighten them. This conflict of interest has caught the attention of Chinese regulators. But the issue won't be resolved anytime soon. From now on, Chinese companies, especially those with derivatives already on their books, should watch for what really motivates their bankers.
