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.