Inside Financial Services

Proprietary Trading Does Too Provide Benefits To The Banking System

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In the FT, Paul Volcker defends the Volcker Rule:

Is there really a case that proprietary trading is of benefit to the stability of commercial banks, to their risk profile and to their compensation practices and desirably fiduciary culture? I think not, and we need to look no further than Canada for a system in which its large banks have been much less committed to proprietary trading than a few US giants. In any event, there are and should be thousands of hedge funds and other non-bank institutions ready, willing and able to undertake proprietary trading in unrestricted securities in large volumes. The point is that those traders should not have access to the taxpayer support implicit in the safety net of commercial banks.

I’m amazed Volcker couldn’t do better than this. First, if nothing else, during the runup to the housing collapse the “benefit to the stability of commercial banks” provided by proprietary trading was he fact that those proprietary positions were largely invested in something other than subprime mortgages. Proprietary trading by the big banks played no role in bringing the U.S. financial system to the brink in 2008. The problem was just the opposite: the banks were nearly done in by assets they thought were the safest: those gilt-edged, AAA-rated mortgage securities banks were creating and selling to investors. Virtually all the big banks owned them, and in size. So when mortgage credit began to crack, everyone owned the same type of rotting assets and was momentarily at risk of all going down together. It was what Peter Wallison calls a “common shock.” Prop trading had nothing to do with it. If anything, the desks provided a measure of needed diversification.

That’s the benefit proprietary trading can provide. The more different businesses (including prop trading) a bank is involved in, the less likely that any single business will put the enterprise at risk. It is basic, and obvious. Don’t they teach this stuff in business school anymore?

Meanwhile, Volcker seems to concede that proprietary trading and market-making are worthwhile activities (he has no problem with hedge funds and other non-banks getting into them). If it’s good enough for non-banks, why then not banks? They have the expertise and the capital. And for me, at least, one common shock per lifetime is plenty.

What do you think? Let me know!

8 Responses to “Proprietary Trading Does Too Provide Benefits To The Banking System”

  1. John Reed

    “Without strong rules that align interests, we will see another race to the bottom,” Reed wrote. “Traders, management directors and even shareholders will seek to game even the best- written rules governing permitted trading in the hope that they can attain the supersized rewards made possible by high-risk investments.” The curbs could put more downward pressure on compensation for Wall Street, where firms already are slashing pay packages and changing compensation formulas as they grapple with lower revenue. Some are giving less cash and more stock, or deferring a greater percentage of total pay. Citigroup cut bonuses for investment bankers by an average of 30 percent, a person briefed on the matter has said.

  2. John Reed

    It’s very simple, Brown. The lunatics have no skin in the game and the taxpayers are on the hook.. It’s an asymmetrical risk proposition (just like management stock options): Heads– traders get fat bonuses, Tails– they stick me and the taxpayers with a wrecked bank.

  3. oy

    They have the expertise and the capital…..and the deep-pocketed taxpayer to bail them out when they screw up. That’s the problem.

  4. Noel Busch

    In my day as a commercial banker, trading provided needed flexibility for real-time alignment of the bank’s asset/liability mix while offering additional potential for profits not otherwise realized…clearly both benefits to the bank. Seems the issue has more to do with compensation structures that are not clearly integrated and aligned with safety and the interest of stockholders.

  5. Blindspot

    “AAA-rated mortgage securities banks were creating and selling to investors” Yes they were creating them and selling them. But AAA-rated?????? Only in name only, certainly not in substance and quality. The rating agencies were getting paid handsomely to rate the pools as quickly as possible without the expertise and or transparency to see what they really consisted of (IO, Low Doc, No Doc, No Verification Loans, Make up Income loans). Unbelievable. If they want to conduct proprietary trading then do so with legally enforcable clawbacks of at least three years back, in the event of losses, for all traders income and bonuses and the income and bonuses of the top 50 executives. Bonuses for one year not paid until the very end of the next year. Plus, have annual reserves against such trading. That will make sure that they perform well.

  6. grover13

    “If it’s good enough for non-banks, then why not banks?” Ummm…..MF Global, anyone? And besides….while the pressure of under-performing mortgages certainly crippled the bank system, that’s not what put Lehman under. What put them under was when all of their capital sources pulled their repo lines, because there was a fear of Lehman exposure to Credit Default Swaps….which no one could justify or un-justify, because they are completely unregulated and unaccounted for. It’s pretty simple: If you want to prop trade- start a hedge fund. If you want taxpayer protection- start a bank. Absolutely nothing wrong with that concept, for entities and investors alike. To insist on co-mingling the two can be boiled down to one word: GREED.

  7. charlie1939

    What the banks ought to concentrate on is BANKING. If they want to be risk takers, we must stop allowing them to have the socialistic back-up from the government. Brown mentions the sub-prime mess as if the banks had no role in that shell game, where, for example, they bet with derivatives against their customers interests. they should have been spending their efforts to verify or disprove that the lies about the sub-prime garbage they were bundling to foist off on their customers were actually AAA. The fraud they perpetrated by not looking into the verity of teh ratings by the ratings agencies is criminal and will one day be their downfall. If they had done their homework and researched the drek they were selling to their customers, there would have been no financial collapse. The proper role of banks is to grease the economic machine by making loans, taking deposits and generally being supportive of the business and household banking needs.

    I believe that Mr. Brown is overlooking the need for the banks to be useful to the society as a whole, not a bastion of unparalleled greed without having any value to the economic system other thatn sucking huge bonuses out of their flow of funds. Volcker has no skin in this game and is in an excellent position to judge whether the rules should be changed or not.

    It seems to me that anyone who is against tighter regulations for the banking, hedge fund and other financial entities is just trying to promote another collapse. After all, would you play poker when there were no rules???? Seems like the banks want no rules, let the “vampire squids” run free…

  8. JRG

    Tom, your view here is ridiculous. Banks need to focus on taking deposits lending and meeting the financial needs of their retail and commercial customers not trading for their own account to mange earnings or boost executive comp. This does not need to be a complex argument – banks that take insured deposits or have access to the fed window should not be using those funds for proprietery trading. Why should taxpayers subsidize an activity that that actualy provides no benefit to them and actually puts them at risk?

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