New Bank Regulation

I wanted to resist commenting about the “Volcker Rule” until the details were finalized, but let me just spit out a few things.  First of all, I spent time on both sides of the business on Wall Street – on the “sell side,” on a customer-related trading desk, and on the “buy side” at an internal hedge fund at the same firm – a large, generally commercial bank.
The second part of my job description would be pretty clearly banned under the proposed rule changes.
“The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.”
You know what – it’s kinda hard to argue with that.  I was just discussing it with a friend of mine who trades in a purely proprietary group (when I say pure prop, I mean it’s completely segregated from all customer businesses – it’s even in a different building usually) at a large commercial bank.   He wrote to me, “but there is very little risk in a group like this – you think we caused the financial crisis?”  And no – neither his group or any group like his caused the crisis, but I explained to him that the higher level concept of the group was the problem – he was trading MY deposits – that’s just not what The People want. Never mind the issue of if my friend trading merger arb with my deposits is any more or less risky than his bank instead taking the money and lending it out to small businesses and homebuyers (cause that’s what they do!) – I think the past few years have cemented the fact that mortgage lending is not necessarily less risky, but it certainly looks better on paper, in terms of subjective categories like benefit to society.
Now the real issue is in my original job – on a customer related trading desk.  We would make a lot of money, like all other trading desks, on risks we took trading around customer flow.  We would provide capital and take risk from clients who wanted to unload portfolios, and then the risk would be on our books.  Trades were coded as “agency,” – that’s a customer order, “customer facilitation” – that’s when we take the other side of a customer order (thus establishing positions of our own), or “principal,” – that’s when we trade out of the customer facilitation trade.  Yet, not all principal trades are proprietary – in fact, most of them aren’t – MOST of them are customer related.  When do you draw the line?  What if I want to hold that customer related position for a day, or three days – at some point does it cease to become a customer related trade, even though it was established as a result of customer orders?
When an S&P index change was announced, we’d usually buy the stock.  First, because we hoped it would go up, and second, because then we’d have inventory to sell to our customers.  We were willing to take the risk of buying the stock early, while they were not.  Fixed income syndicate desks are the same – when underwriting a new bond issue, of, say, $300MM for XYZ corp, the desk may sell $315MM worth of bonds to its customers and end up short the issue, so it can go out and actively bid for bonds, since it knows that some customers will want to sell their allocation quickly.  It’s part of being an intermediary.
Are these activities proprietary trading?  That’s the real question.  People are talking a lot about Goldman Sachs, a firm who makes most of its money from “trading.”   GS, however, claims that roughly 10% of its revenues are from purely proprietary trading.  The remainder is from customer related desks.  Are these desks taking principal positions?  Of course – and how do you pick and choose which to allow based on customer flow interactions?  You can’t be a little bit pregnant, and you can’t kinda-sorta ban proprietary trading.   John Hempton brings up a few more easy dilemmas on the difference between prop trades and hedges: “You do a big equity underwriting. To hedge your risk you go short the market because you can’t go short the specific.” Is that a prop trade?  “How about guaranteeing a customer VWAP on a trade. Is that prop risk?”
Unfortunately, it seems like this policy is more populist reaction from an Adminstration that screwed it up the first time.  Take Goldman Sachs (And Morgan Stanley for that matter) – why on Earth are they allowed to borrow from the Fed under Bank Holding Company charters when (to the best of my knowledge) neither of them has any commercial banking deposits?  (EDIT:  EconomicsOfContempt points out that both GS and MS actually do have bank deposits.  I think the gist still holds here though – try opening up a retail depository account at either of these institutions.  The Fed window is designed for capital needs related to retail deposits in order to avoid runs on the bank) In addition to trying to separate commercial banking and prop trading, wouldn’t a good first step to be to actually separate the commercial banks from the non commercial banks?   People aren’t mad because GS is making money trading – they’re mad because GS is making money trading with what they (the people) think is taxpayer money or taxpayer backstops.  The decision to allow non-banks access to  (near zero cost) Fed funds resulted in these non-banks making extreme amounts of money which angered the populace.
As I said, I fully understand the desire to implement a situation where commercial banks do not engage in proprietary trading.  However, the real problem isn’t proprietary trading – it’s leverage – it’s actual risk.  Even if/after we successfully separate proprietary trading from commercial banking, what are we doing to prevent the next Long Term Capital Management blowup?  I guess LTCM is no big deal anymore – after all, it was a mere $5B in bailouts – chump change in today’s land of large bailout numbers…
-KD

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