Bookies, Banks and Fiduciaries

A bookie is an arbitrager. He has no skin in the game; rather, he uses odds (the parallel in finance would be interest rates) to earn money on each bet that is placed (each financial transaction). The odds are always variable unless you are willing to pay a fee to lock it up.

At yesterday’s financial committee hearings, Loyd Blankfein gave a general overview of his firm’s risk management management practices: to paraphrase, risk mitigation is achieved by finding a third party to take the other side of the transaction. Fees from brokering these investments are a significant source of revenue for most investment banks. The research divisions of these same investment banks will also put out opinions on the direction of the market for most of asset classes, fortunately for bank, 50% of their customers will make sound investment decisions.

The issue in late 2008, was that the third party (AIG) in many of these transactions took on way too much risk from numerous investment banks. They put everything on black, and they were wrong. The result was that AIG couldn’t make good on their debts and the government had to come to the rescue. The investment banks had significant exposure to AIG’s credit risk and this is where the domino’s would have begun to fall.

Imagine a bookie in a similar situation. He takes a bet on opposing outcomes from each of two parties; one wins big money and, all because of overextending himself, the loser can’t pay. What’s a bookie to do?

If the financial committee could see the banks in the same light as a bookie operation, it would clear up much of the confusion over how to handle any future regulations. It seems apparent that a transaction tax could be levied or that banks can be required to have more skin in the game.

This brings up accounting issues, but should banks be required to hold some portion of every transaction on their books? How much is enough? Is 8% of risk weighted assets enough? Is there a better way? Let me know in comments.

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