Captain Phillips

Institutional acquisition is an acute form of institutional capture.

My first job after the service and graduate school was as a market maker in foreign exchange options for a mid-size bank. I worked for several of these before going to business school. It was kind of like being a cornerback for the Cleveland Browns. You were in the NFL but you weren’t in the first-tier.

The first-tier banks had the flows. When some large hedge fund or a central bank wanted to execute, they weren’t coming to you. They were going to the Bigs. Those trades could move markets in an instant. Either the Bigs laid off their risk with you (and potentially ran you over) or they traded around you (and potentially ran you over). Most of the time it was boring, but there were moments of hair-raising terror. I started as a trainee for several months on the spot cable desk (the British pound against the US dollar) right after the pound left the Snake (the Exchange Rate Mechanism). I assisted the senior trader as we made markets to the Bigs in order to be able to preserve liquidity for our own (smaller, less informed) customer flows. I can still remember the first time we went into action on a particularly frantic day. My palms were cold and clammy. I thought I was going to throw up. I loved it.

The expectations were low. You were there to preserve the profits generated at the retail and mid-market level while generating some additional profit from making institutional bid/offer spread, picking up pennies along the way with the hope of not being knocked flat when the occasional gunfight erupted on the mean streets. Really the mandate was just don’t lose any money, make a little on the margins, and lock in the spread from the flow. The value of the franchise was the bank’s, not yours. At least that’s what the culture told us. Management seemed to think that a nutless monkey could do the job given the right training. This wasn’t true, of course. It was tremendously difficult.

It was great training!

You had to learn how to read the plays. You had to pick your spots. You had to do it all without the expectation of a powerhouse quarterback or much of a team behind you. You were there to be in the game.

The Bigs were generally large American and European institutions. Bankers’ Trust was the first name I learned to fear. They were the best. I picked up the fear from the senior trader I assisted. He was a nervous, angry, inarticulate dude. We had a desk drawer full of replacement handsets for the telephone turrets because he would break them so frequently. Keef. He and I got along famously. When Bankers called on the Reuters terminal, his face would turn red and he would start snapping his fingers at the screen to get me engaged, as if I wasn’t lit up already. Those were the days. It was a young man’s game. I had a chip on my shoulder.

In addition to BT, there were Citi, Deutsche, Swiss Bank (really O’Connor), UBS, Goldman (J. Aron), JP Morgan, Chase, Chemical. They were the Patriots, the Chiefs, the Seahawks of the FX markets in the 90s. Like I said, I played for the Browns and then the Raiders, and eventually (in a terrible lapse in judgment) the Jets. I just liked playing the game and I had been recruited out of a backwater, not one of the powerhouses of college football. Eventually I moved on. You can’t play games your whole life.

One of these Bigs (call it Mega Bank) had a fantastic operation in that they were spectacularly well managed. The head of FX for the Americas based in NY was by all accounts an outstanding trader/speculator, a wonderful manager, and a world-class salesman. He was a unicorn of an executive. Sometimes you would see people who were good at trading but were poor at managing or dealing with the politics of a bank or who couldn’t sell. It was rare (but not impossible) to find people who combined this trifecta. They exist today. They are worth their weight in gold. The most common thing to see instead was someone who had risen up the trading ranks and been promoted beyond their skill set into management despite possessing no leadership or administrative skills. Despite possessing negative leadership skills. Bad managers can break the best franchises.

So it was with Mega Bank. The FX desk was succeeding in every dimension. They led the League tables as one of the top five FX banks in North America. They had relationships with every significant customer. They were massively profitable. The team was stable. Why leave? With the Manager in charge, the traders could do their jobs, get paid well, and live their best lives.

Then one day, a propos of nothing, Mega Bank announced a change. The rockstar Manager was out. I can’t remember what happened. I think he was banished to some remote posting as punishment for his uncomplaining success. Mega Bank announced his replacement, someone with no real profile in the trading world. The staff were disconcerted, angered by the dishonorable treatment of the Manager but, more significantly, concerned about what this meant for their own positions. The good ones, the old hands, started looking for jobs straightaway; the more naïve hung on thinking that the new chap couldn’t mess things up immediately.

The new guy screwed the pooch very quickly. The rumors in the market flew fast and furious. He was cutting incentive pay. He was replacing key trading staff with his own people or less experienced hands. He was cutting back on the travel and entertainment budget. I never figured out what exactly he did. Within a year, it was broken. The profits. The League tables. All of it.

Mega Bank had destroyed a franchise by replacing the coach for no reason other than that the new fellow wanted the winning seat. Mega Bank management and the new fellow assumed that their success would continue, that nothing would change. They didn’t understand how fragile their position had been, how much it relied on execution. They made these mistakes because Mega Bank was a large commercial bank. It was if the Patriots had been owned by the Department of Motor Vehicles.

This whole episode is an example of a type of institutional capture.

‘Institutional capture is a phenomenon where regulated industries or powerful private interests exert undue influence over the government agencies, regulatory bodies, or international organizations intended to oversee them. This influence can result in rules, policies, and enforcement actions that primarily serve the interests of the regulated parties rather than the public welfare they were established to uphold. The process typically occurs subtly through revolving doors, funding dependencies, and lobbying pressure.’

Imagine a powerful lobby, like the climate change lobby or the chemical industry, seeking to sway environmental policy by penetrating the relevant regulatory organizations with money, political influence, lucrative job offers for senior officials, or other types of moral suasion. We’re all familiar with it. We can all imagine it.

There is a more basic type of institutional capture. It occurs when an individual or a group of people take over an institution to promote their own personal interests. Call it institutional acquisition. It’s bureaucratic hijacking. I’m the Captain now.

In the case of Mega Bank, the new manager assumed that things would continue to run smoothly. Anything he did, he assumed, would have no pejorative impact on outcomes. Ideally, he would preside over the FX desk like a figurehead and enjoy the spoils of power. He would use this as an opportunity to acquire a bigger, better position.

You see this in all kinds of bureaucracies. Imagine a government agency where the leadership changes over to someone who is good at making presentations at conferences but who cannot execute, someone who is effective at office politics but poor at leadership. They make big speeches about how they are going to do this and how they are going to do that, but a year or two in office and nothing happens.

The reason this takes place is that the institution itself is unaware of the intangibles that factor in the success of its subsidiary units. They don’t see the data that isn’t quantified. They take things for granted by policy paper writers and smooth talkers.

Given that we’re in the prediction business, how does this knowledge help us?

If you start seeing signs of institutional acquisition, it’s a powerful signal of organizational rot. There is never just one cockroach. Leadership doesn’t understand how things work. The culture is corrupted. It foreshadows future weakness.

Get out while you can.

Eternal vigilance is the price of excellence.