"One of the areas most misunderstood in risk management is reputational risk," says Ed Altman, professor of finance at New York University's Stern business school. "A single event could blow up an institution.
"When the most knowledgeable party is also the one structuring and taking positions, that has been argued as going beyond what a prop desk should do," he adds. "It goes beyond inventory accumulation [to help flow trading business]."
Prop desks are confronted with conflicts. They are charged with making money for the institution, but their actions can sometimes prejudice the interests of other units' clientele.
This week at AsianInvestor's conference on distressed asset investing, a panel led by Altman considered the issues around investment banks having businesses in so many stages of a distressed-asset sale, from underwriter to structurer to seller to buyer. The discussion was planned before the US Securities and Exchange Commission sued Goldman Sachs for alleged fraud, but the Goldman case dominated the discussion due to its "tarnished reputation", says Altman.
"Prop desks are a necessary evil," says Stephen Le, Asia-Pacific head of distressed product trading at Deutsche Bank, adding that his firm is more of a flow shop than a prop shop and that, for Deutsche, prop trading is not all that important.
A majority of industry professionals in the audience, temporarily adopting the guise of US Senators when quizzed by Altman, voted to pass the 'Volcker rule' that would separate hedge-fund and private-equity activity from deposit-taking banks.
So what percentage of investment bank revenues is sourced from prop trading? The range expressed at the conference was from 10% up to 80% for the IBs who most like to dress in hedge-fund clothes.
"If an investment bank creates a product either for themselves or as something predatory or as one that sets out to hurt somebody, that's a dangerous area," says George Long, founder and chief investment officer at Lim Advisors in Hong Kong. "Club deals where a bank shares with another five investors don't bother me as an ethical issue, but I've seen deals in Japan where one investment bank has taken an entire deal onto its own books."
Edwin Wong, once a successful prop trader at Lehman Brothers in Asia, and now manager of his own Hong Kong-based distressed fund, SSG Capital, says conflicts of interest have always existed with regard to investment banking. What matters is the controls that are in place to make such conflicts transparent.
"You can't remove the conflict issue," Wong says. "The guys who put on the trades don't get compensated for protecting reputational risk, so that is where a lot of the reputational risk arises."
A big problem at Lehman was the fact that beyond its distressed business -- ie, on the proprietary real estate side -- those who made reputational decisions chose not to carry out independent checks to question the data being provided by their business-management staff. Their bonuses, too, were governed by their business lines making big bucks.
IBs do the right thing, according to the panel, when they place an investment banking relationship ahead of a prop desk position. In such cases, the longer-term investment banking relationship would probably override the prop desk's desire to massively short the client's stock or its interests. Positions come and go, but relationships - and reputations - endure.