Weekend Reading: What’s an Old Cowboy to Do?

By: Dan Davies, Author of The Unaccountability Machine

This piece first appeared in Starling Insights' newsletter on November 17, 2024. If you are interested in receiving our thrice-weekly newsletter, among many other benefits, please consider signing up as a Member of Starling Insights.

I pre-ordered Duncan Mavin 's book, Meltdown: Scandal, Sleaze and the Collapse of Credit Suisse, as soon as I'd heard he was writing it. Somebody needed to write the story of how my former employer fell apart, and Duncan's previous book on Lex Greensill was fantastic, so I'm excited to hear how he handles the Credit Suisse story.

But before the failure, it ought to be remembered, Credit Suisse was a success. Before my perception is distorted by reading all the details of what was going on behind the scenes, as recounted in Duncan's new telling, I want first to record here what it was like to have been there, in the glory years, as a relatively junior employee before the financial crisis…

I suddenly understood what it meant to have a "corporate culture" one afternoon on the Credit Suisse equities trading floor, in the 2000s. (I am not sure of the precise year).

But it was spring, I'm pretty sure, and I was working as a research analyst. As we often did in those days, before various rules got clarified, I had wandered down to the floor to alleviate the boredom, and to talk to the sales desk and traders. It was not a great source of distraction, but then we didn't have iPhones in those days.

That particular day, however, was much more exciting than usual. Everyone wanted to pass on the latest scandalous gossip, and it was being rumoured that six prop traders had taken big positions, all in the same small-cap oil services stock.

It might be necessary to explain why this was a scandal, because times have changed quite a lot, and a whole generation has entered the market since proprietary trading at banks was phased out. But the Credit Suisse "prop desk" was like a little internal hedge fund. They invested the bank's own money, buying and selling stocks to try and make a profit.

The prop desk traders were separated from the client-facing traders, to avoid any perception of front-running orders. But they weren't separated very far; although they weren't able to see any individual order, they tended to pick up a good idea of the overall direction of trade flow. And if you were positioned near to an active market-making desk, a good sense of flow can provide you with a substantial edge on the market.

So why was it a scandal that six traders had made similar bets on the same company? Basically, because proprietary trading is risky. They were putting the bank's capital at risk, so each trader was subject to strict limits, particularly when it came to investing in stocks that might be illiquid. They shouldn't have been sharing stock tips with one another, and building up six times the individual position limit, even if the tip was especially good.

I am not sure whether the rumours were true (I suspect they were exaggerated) but what sticks in my mind is that, if it was true that these traders had acted in concert, everyone on the trading floor knew it would be scandalous: desk assistants, IT support staff, and even I knew where this left the firm, despite having only joined a short while earlier and never having had any formal training in the risk management of prop desks. Somehow, everyone on the Credit Suisse dealing floor knew that prop traders shouldn't be sharing positions.

Dan Davies' latest book,?The Unaccountability Machine, will be featured on the Starling Bookshelf in our 2025 Compendium, coming next Spring.

Alfred Marshall, in his "Principles of Economics" said:

When an industry has thus chosen a locality for itself, it is likely to stay there long: so great are the advantages which people following the same skilled trade get from near neighbourhood to one another. The mysteries of the trade become no mysteries; but are as it were in the air, and children learn many of them unconsciously. Good work is rightly appreciated, inventions and improvements in machinery, in processes and the general organization of the business have their merits promptly discussed.

This was true of knife-making in Sheffield in 1890 and it was true of Credit Suisse a hundred years later. More than any other bank I ever worked at, risk taking was in the air at CS. Everyone believed it was the way to make money. Taking risks is what we were there for.

I'm sure this attitude helped all the parts of the sales and trading business — our salespeople and analysts were that much more simpatico with hedge fund clients, simply because we spent more time talking to risk-takers and absorbed more of their world view.

Paradoxically, this was a very safe business model. If Mark Twain had been a risk manager, he would certainly have said that it's never the risky business that blows up on you — it's the safe stuff that ain't.

When I worked at Credit Suisse, we were cowboys, but we knew we were cowboys, and our senior executives knew that they were managing cowboys. If you're managing cowboys, you do so by putting strict limits on them and monitoring them very closely.

In turn, the staff knew that risk management was part of the job of risk taking. Someone who pushed a VaR limit was potentially making things harder for the rest of us. To cluster in a crowded trade would have been a shameful action.

Nobody concealed losses while I was at Credit Suisse. Indeed, you wouldn't even joke about doing so. Compliance and reporting staff were as much of a pain in the neck as they were everywhere else, but there was a sort of grudging understanding that we needed them. In sum, a certain knowing approach to risk management was deep in the blood at pre-crisis Credit Suisse, and it worked.

When the Great Financial Crisis came, CS was one of the big relative winners. Sure, there were some losses on subprime mortgages and leveraged loans, but we didn't take any government money and trading losses were some of the smallest on the Street.

Much later, it turned out that the origination of those mortgages had been much worse and resulted in a very big regulatory fine. But, regardless of any of that, the age of cowboys was over. Proprietary risk taking was gradually phased out. CS needed to reinvent itself, as a leaner and smarter business, which intermediated and managed, rather than taking all the risk on its own balance sheet.

Credit Suisse was terrible at this kind of risk management, it turned out.

Cowboys take the kind of risks where someone will look you in the eye and shoot you in the front. You know that it's a zero-sum game you're playing, and that the counterparty who said "92 offer" has their own reasons for preferring that to "91 bid". You know that you have to assume that every unknown factor that's under someone else's control is going to be manipulated to serve their advantage over yours, and that you have to be content with the trade, even on that basis.

After the crisis, the investment banking industry was meant to start taking risk like "city slickers" rather than cowboys.

If you have a relationship of trust with a client, you are expected to try and create win-win situations and to make sure your incentives are aligned. Most of the time they are. And even when they aren't — or, at least, not precisely — you can usually rely on the client to behave honourably, simply because they want to do business with you again.

Per this mindset, risk management is not about trying to outsmart a thousand good clients, it's about identifying one or two bad apples.

There will be a lot of stories in Duncan's book about how risk management failed with Lex Greensill, Bill Hwang, the Mozambique bonds and all the rest of the recent vintage scandals at Credit Suisse. But I would diagnose the problem at the firm quite simply — you can't turn cowboys into city slickers.

For more from Dan Davies, don't miss his contribution to the upcoming 2025 Compendium,?due out next Spring on Starling Insights.

Dan Davies is the author of several books, most recently The Unaccountability Machine: Why Big Systems Make Terrible Decisions — and How The World Lost its Mind. He is a former Bank of England economist and investment bank analyst. As a journalist, he has tackled the LIBOR and FX scandals, the collapse of Anglo Irish Bank, and the Swiss Nazi gold scandal. He has written for the Financial Times and the New Yorker.