Sunday, February 28, 2010

Is the Volker Plan shadow boxing or can it help?

Volker Plan and Banks’ Proprietary Trading for Their Own Account (Prop Trading)

As to the Volcker Plan, many pundits couldn’t figure out why Obama’s effort to have a fight weren’t getting any takers. Others participate in his charade by pretending he is battling demons. That the Republicans are indifferent isn’t surprising. But where are the bankers?

In the weeks following the announcement, a couple of analyses of proprietary trading at banks were published. They made clear why most of the banks were so indifferent. A number had already closed down their prop trading desks and sold their hedge funds. Of those that still have operations, the largest operation was responsible for about 5% of profit of the firm (but the contribution varies from year to year). For the few firms with prop trading operation or hedge funds, selling them would bring in a nice chunk of change. Pending additional information, it seems clear that prop trading at banks and systemic risks are not very closely related. Prop trading at non-banks is an issue, but that widens the scope.

On the flip side, as it relates to bank stability, the negatives regarding the proposal on prop trading are minimal. The main downside is that people will think something has been done about systemic risk when it hasn’t. Clearly, systemic risk needs to be addressed, and this doesn’t do it. It would be unfortunate to see this played for votes instead of remedies. But it is fun to watch the president play the fighter when there’s no opponent except common sense.

Unfortunately, combined with other elements of the Volcker Plan, the proposal means more of us will be banking with foreign owned banks. But since I bank with TD and was with Citizens before that (both foreign owned), I obviously don’t care too much. But then, selling US banks to foreigner could be the next US export boom. We’ll just import a little more banking services.

The prop trading prohibition doesn’t address systemic risk, just where it is. The Volcker Plan forces some prop trading activities out of banks into hedge funds. Hedge funds already contribute to systemic risk and are more leveraged. It may even increase risk to the banking sector since more control of the level of leverage will be controlled outside the banking sector. For the banking sector, which lends to hedge funds, the risk could shift form; the trading risk becomes creditor risk and the credit risk is accumulated in a less stable systemic environment. If banks lend to hedge funds, under the Volcker Plan they can’t own a stake. What’s their recourse in a default? Since they can’t ‘take’ the hedge fund that is in danger of failing, their recourse is restricted. Long Term Capital Management illustrates the point.

From a regulatory perspective this isn’t too important except that it isn’t a good sign that a shift that is occurring anyway is being seen as a solution instead of as a new source of risk.

Trading fees would probably convince some of the remaining banks to give up prop trading anyway. However, more importantly, and very importantly, trading fees would include hedge funds, insurance companies, GSEs, private equity, etc. doing proprietary and quantitative trading, not just banks. It’s clear the systemic risk didn’t originate from banks, prop trading, or quantitative trading. Quantitative trading did cause some of the contagion even if it wasn’t the root cause. But, hedge funds seem to have been the more important vehicle, not banks. In fact, hedge funds were probably instrumental in transmitting the downturn from debt markets to equity markets where they had an impact on a broader set of individuals through their 401k’s and IRAs.


  1. I would argue that adding a regulatory framework around prop trading desks is not the way to go.
    Why not just make investment banks with significant prop trading to revert to the partnerships that they used to be. There was very little of the collateralized default swap origination, the immense underwriting of dubious securities like alt a mortgage backed securities and collateralized loan agreements when partners' capital was at risk.

  2. Does the type of institution taking risk matter?

    In a comment to an earlier posting (February 28, 2010), a reader (the Professor at ) pointed out that ownership structure influences attitudes toward risk. It is a point well taken. But, the point of the February 28 posting was that moving the risk doesn’t reduce the risk. If it is moved from regulated to unregulated or to more leveraged institutions, it could actually increase the risk in the system. So, I left the Professor’s comment as a net addition to the discussion because it raised a multitude of important issues.

    The Professor was actually introducing a new topic. The strength of the Professor’s point rests on the contention that ownership structure influences risk attitudes and ,thus, the total risk in the system. But, the ownership structure for organizations taking the risk is only weakly related to who owns the risk. An individual can start a hedge fund or private equity fund and then gear up the leverage to phenomenal levels. They can do it by borrowing or through the instruments they trade. And, yes, many of them have their personal capital in play, but others don’t. More importantly, they don’t need to be a bank or even a public company to do it.

    Also, ownership actually cuts both ways. It may be possible to manage organizational ownership in ways that cut risk appetites as the Professor pointed out. His suggestion may do just that. But, if it shifts risk to a thinner capital base, it could increase leverage risk enough to offset the impact on risk appetites. The net effect isn’t immediately apparent, especially if the leveraged players are pursuing a common strategy (a crowded trade in trader jargon). Those leveraged organizations don’t have to be banks or even publicly-traded institutions.

    The Professor’s suggestion also has much broader implications than just ownership. The generalized problem that supports the Professor’s position is that there are what have come to be known as agency problems. The interests of the agent (the player) don’t align with interests of other constituencies. The financial service industry is rife with them.

    His reference to “when partners’ capital was at risk” highlights one way to address one of the agency issues. But, whether it is enough, seems to me to hinge on the importance of conflict between the interests of traders verses capital providers. I think it’s broader than that.

    Finally, I delayed commenting because without addressing resolution authority, too big to fail, derivative markets, etc., I thought any comment I made would sound naïve and argumentative. Since I thought his comment added to the discussion, I certainly didn’t want to appear argumentative. He proposed a response. His comment was constructive. Alternatives are always worth considering.

    So, ownership structure matters, but I thing, not know, just think, it isn’t enough.