Thursday, December 12, 2013

What the Volcker Rule Reveals About Wall Street

What the Volcker Rule Reveals About Wall Street

Former Fed Chairman Paul Volcker had a really good idea.  He suggested that banks shouldn’t be able to speculate using capital that enjoys implicit or actual government guarantees.  The practice is known as proprietary trading.  Stated slightly differently, proprietary trading is when a bank trades for its own account.  Historically, banks have traded securities for three general purposes: to make markets for cl ients, to hedge positions (reduce the risk of a loan or security), and to trade for their own account.  Traditionally, there’s been a great deal of fuzziness around these three activities.  However the fuzziness didn’t matter because all three activities were legal.
Pension Risk (2002)
As a portfolio manager, I detested the proprietary trading desks at the major Wall Street firms.  Working for large institutional money managers, I had to do business with the likes of Goldman Sachs, Morgan Stanley, and Merrill Lynch.  My contacts at these firms assured me that they were only interested in providing me with the best possible execution even though their colleagues on the proprietary trading desk might not have my best interests in mind.  The banks tried to allay my concerns with a steady stream of invites for steak dinners and sporting events. 

They also argued that proprietary trading had the valuable benefit of providing liquidity for the markets.  Wall Street continues to makes this dubious argument. Proprietary traders only provide liquidity when the markets don’t need it.  When the capital markets become unstable, the proprietary desks are among the first to disappear from the markets.

Let’s be clear.  Proprietary trading benefits senior Wall Street executives and a cadre of traders.  A large portion of the seven and eight figure bonuses paid out by Wall Street banks is the result of proprietary trading.  Aren’t the bank’s shareholders beneficiaries of these profits?  Yes, they are but to a much smaller extent than the executives or traders.  Trading profits are volatile, and thus investors tend to ascribe less value to them than profits generated from other banking activities. 

Mr. Volcker’s rule attacks one of the most misaligned aspects of Wall Street.  If proprietary traders create profits, a handful of people make tons of money.  If proprietary trades generate losses, the executives and traders don’t lose anything.  They’re never asked to give back the bonuses from profitable years.  Yet shareholders and potentially taxpayers bear the risks.  Don’t executives and traders lose as shareholders when trades go bad?   They suffer a lot less than your average mutual fund or institutional pension plan.  The executives have plenty of cash compensation to fall back on as well the prospect of receiving more stock options or grants if the existing ones fall in value.

Why is the Volcker rule over 900 pages? And why did it take years to finalize? There are two reasons.  First, it isn’t easy putting a bright line around market making, hedging, and proprietary trading.    Turning the former Fed Chairman’s idea into practice involves parsing innumerable nuances among various types of trading activity in different markets.   Moreover, proprietary trading can be easy to disguise.  For example, a bank might be short millions of dollars of a certain commodity.  Are they short because they were making a market for a client?  Are they short because they’re hedging the exposure somewhere else in the bank?  Or are they speculating?  The new rule has to differentiate between these situations.

However, there’s an even bigger reason the rule is 900 pages, and it can be seen in the instantaneous attempts by Wall Street and its legal representatives to look for loopholes.  Wall Street’s culture is rotten.  If Wall Street accepted the idea that they shouldn’t be speculating using the actual or implied guarantees of the government, the rule could be a page or two.   Wall Street firms would err on the side of avoiding even the appearance of proprietary trading.  However, Wall Street takes the opposite view.  Wall Street will go right up the line and even tiptoe across if the line isn’t clear.  Why?  Because big bonuses are at stake, and because they know we’ll bail them out if their bets go terribly wrong.

I’ll have much more to say about values in my Sunday column in the Raleigh News and Observer.

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