The Volcker Rule & Proprietary Trading

Tuesday's Wall Street Journal featured an article concerning the definition of proprietary trading in a Volcker Rule world.

Personally, I think this is much, much ado about nothing. Hairsplitting, if you will.

Consider this passage,

"But does that mean a trader can't buy a bunch of bonds in anticipation investors would want to buy them a week later at a higher price? What if the trader holds the bonds for a month or two? Such scenarios make it difficult to draw a clear line between proprietary trading and the sort of client-centered trades typically handled by separate desks at most firms."

The answers, in the real world, are: yes, too bad, and, no, they don't.

See, only in the self-referential world of professional trading and investment banking could such an otherwise-clear and unconditional rule or concept be twisted like a pretzel to try to get the result the interpreter desires.

For example, if such pre-positioning were legal under the Volcker Rule, who would own the profits of any such pre-positioning? The client who didn't request it?

Not unless you're Red Bone, your client is Hillary Clinton, and you're trading cattle futures.

It's highly unlikely that institutional clients want their execution desk running speculative books on their behalf. For that, they typically invest in hedge funds. Where they expect such activity.

The Volcker Rule is very clear in its intent. Any institution which takes insured deposits must refrain from speculating with their own capital, because those losses are fungible and, if they result in bankruptcy, the taxpayer must foot the bill for deposits which are essentially lost.

How hard is this to understand? Really?

So, if trading is done on behalf of a client, but not in their custodial account, with their money, that would be------ proprietary trading!

See how easy that is?

The Journal ends with a paragraph containing this passage,

"Goldman President and Chief Operating Officer Gary D. Cohn has said that he expect the firm will be required to get out of "pure prop trading businesses," but he wouldn't rule out ditching the firm's bank-holding company status to gain more trading flexibility."

Amazing. Is this the same Goldman Sachs that came crawling to the Fed in late 2008, begging for a commercial bank charter, so it could borrow at the Fed window and stave off insolvency?

If such a move by Cohn isn't illegal, it's certainly immoral.

This is why Goldman is so hated. And should be, with this attitude.

Just What Is "Proprietary Trading" Anyway?

Much has been made recently of the belief that "proprietary trading" did not actually cause the demise of Bear Stearns or Lehman Brothers, and, thus, is of no consequence in the evolving FINREG bill.

I believe this is wrong. It takes too narrow a view of just what proprietary trading actually entails.

To me, proprietary trading may technically define or describe only those as-principal activities on an investment or commercial bank's trading desks which risk the firm's own capital.

However, the broader notion meant by people like Paul Volcker, in articulating his Volcker Rule is, I believe, that of the risking of a bank's capital on any underwriting, long term investments or high-frequency trading for its own account.

The key common element isn't the duration, which could rule out proprietary trading as the culprit of some now-defunct banks' woes, but, rather, the risking of the bank's own capital in market-valued instruments and activities.

When banks which do this are also in the business of taking insured deposits, then they are implicitly being backed by the FDIC and, ultimately, taxpayers.

Lehman was brought low, in part, by the poor quality of the commercial mortgage assets it chose to hold on its books. That was proprietary investment.

Bear Stearns was believed, by its commercial bank lenders, to have asset quality problems which made those overnight loans too risky.

Were the assets the result of trading, or underwriting, or investment? Doesn't really matter.

They were owned by the firm, and lost more value than there was equity to back them.

Trading...investment.....really, what's in a word, in this case? The time dimension isn't what is important when considering the reform of financial regulations and structure regarding a bank's risk exposure while also taking insured deposits.

The source of the risk capital is.

Volcker On The VAT

Taxes are surely an important element of business.

It's well-known that the famed Bush tax cuts of 2001 expire at the end of this year. We have already seen new tax increases passed into law as part of the recent health care bill. For example, for the first time ever, investment income is now subject to FICA taxes.

It's a conceptual step of significance, since it breaks the original link between wages and social security contributions and payments.

Now, the current administration is widely signaling a move that makes the FICA-taxing of investment income look like a baby step.

I'm referring, of course, to the VAT tax.

Personally, I have great respect for Paul Volcker's opinions on monetary policy and, to some extent, his basic ideas of financial sector regulation. However, I don't recall his being Treasury Secretary. Nor his particular expertise on fiscal matters, such as tax policy.

In fact, Volcker has been a lifelong Democrat. And he consorts with the most explicitly socialist American administration in history.

Thus, it's disappointing, but not surprising, that Volcker announced last week that new taxes will be necessary and, what the heck, a VAT isn't as "toxic" anymore as it used to be.

Huh?

Volcker essentially admitted a VAT is toxic. But, according to Paul, if taxes are needed....because we can't possibly cut spending......well, maybe the time has finally come to succumb to the silent theft of the VAT.

Want to really put any US economic recovery on hold? Make a big push to raise prices on everything by 20%. Because tax incidence always moves to the consumer.

Too bad Volcker didn't stick to monetary affairs and declare himself unqualified on this matter.

Volcker vs. Dodd Yesterday On Capitol Hill

If you happened to watch former Fed Chairman Paul Volcker's testimony on Capitol Hill yesterday, you were treated to some subtle comedy and tactful snubbing.

Volcker was testifying before retiring Senator Dodd's committee on his so-called "Volcker Rule."

After reading a lengthy, clear and comprehensive prepared statement, Volcker entertained questions.

The first one was from the witless Connecticut Senator, himself. Dodd began by presumptuously asking "Paul" to elaborate on how the matter of detecting proprietary trading would be handled. Dodd continued by pontificating on the subject of how difficult this would be, and generally exposed, despite years on the committee, his near-total lack of understanding of modern commercial and investment banking activities.

Volcker responded in an icy tone, fairly dripping with disdain, beginning with a pointedly formal, non-personal "Mr. Chairman."

He then went on to implicitly spank Dodd by casually noting that the answers to Dodd's questions were contained in the text which Volcker had just finished reading.

It was a priceless moment. I think Dodd was probably the only person either in the room or watching via cable coverage who didn't grasp how he'd been humiliated by Volcker in a single sentence.

There's a reason Paul Volcker is iconic, and it was clearly on display yesterday.

Paul Volcker On Financial Innovation

Earlier this week, the Wall Street Journal published a special section entitled "Fixing Global Finance." Apparently, the paper recently hosted a conference involving various senior executives of financial institutions, regulators, et. al.


Skimming through the section, I found nothing particularly interesting, other than Paul Volcker's remarks. Everyone else was either one of many unimpressive, unimaginative executives at a cookie-cutter made global financial institution, or hailed from a damaged one.


But Volcker was much different, as usual.


According to Alan Murray's written piece recounting Volcker's comments, he began,


"Well, you are not going to be very happy with my response. I heard an awful lot of particulars here that I agree with to some degree, but my overall impression is that you have not come anywhere near close enough to responding with necessary vigor or structural changes to the crisis that we have had.


I hear about these wonderful innovations in the financial markets, and they sure as hell need a lot of innovation. I can tell you of two—credit-default swaps and collateralized debt obligations—which took us right to the brink of disaster. Were they wonderful innovations that we want to create more of?

You want boards of directors to be informed about all of these innovative new products and to understand them, but I do not know what boards of directors you are talking about. I have been on boards of directors, and the chance that they are going to understand these products that you are dishing out, or that you are going to want to explain it to them, quite frankly, is nil.

I mean: Wake up, gentlemen. I can only say that your response is inadequate. I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information. I am getting a bit wound up here."


Volcker waggishly announced that, in his opinion, the finest example of financial innovation in the past 20 years, more mechanical than financial, really, was the ATM.


But Volcker's correct. While extending the availability of consumer credit via cards and somewhat more flexible mortgages has been productive, the more esoteric financial engineering products have created more problems than they probably solved. And certainly not contributed to smooth, healthy economic growth.


To provide more conclusive evidence, Volcker reportedly then confided,


"A few years ago I happened to be at a conference of business people, not financial people, and I was making a presentation. The conference was being addressed by a very vigorous young investment banker from London who was explaining to all these older executives how their companies would be dust if they did not realize the joys of financial innovation and financial engineering, and that they had better get with it.

I was listening to this, and I found myself sitting next to one of the inventors of financial engineering. I didn't know him, but I knew who he was and that he had won a Nobel Prize, and I nudged him and asked what all the financial engineering does for the economy and what it does for productivity.

Much to my surprise, he leaned over and whispered in my ear that it does nothing—and this was from a leader in the world of financial engineering. I asked him what it did do, and he said that it moves around the rents in the financial system—and besides, it's a lot of intellectual fun."


The man to whom Volcker refers is almost certainly either Myron Scholes or Robert Merton, both of Long Term Capital Management infamy. It's a very telling tale, knowing this. The sort of comment which those who have always suspected financiers of being careless with the systemic impacts of their risk-related activities find confirming the worst of those suspicions.

Volcker continued,



" I am not sure that I said innovation in itself is a bad thing. I said that I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy. Maybe you can show me that I am wrong. All I know is that the economy was rising very nicely in the 1950s and 1960s without all of these innovations. Indeed, it was quite good in the 1980s without credit-default swaps and without securitization and without CDOs.

I do not know if something happened that suddenly made these innovations essential for growth. In fact, we had greater speed of growth and particularly did not put the whole economy at risk of collapse. That is the main concern that I think we all need to have.

If it is really true that the world economy was on the brink of a great depression that was greatly complicated by financial problems, then we have a rather basic problem that calls for our best thinking, and structural innovation if necessary. I do not want to stop you all from innovating, but do it within a structure that will not put the entire world economy at risk."

I like and agree with Volcker's point that productive, useful innovation is fine. But reckless innovation for the sheer sake of bolstering profit margins, which is actually the genesis of most of the more damaging so-called innovations, is not.

Consider, for example, if, instead of CDOs, financial service firms had created exchanges for trading whole mortgage loans. Instead of being forced to buy packages of loans of varying quality, an investor could diversify risk geographically, or otherwise, himself. Risks would be managed via collateral requirements for the exchange members, so the sort of daisy-chain defaults that so worry investors today would be non-existent.

Further, Volcker implies something I also believe, which is that credit derivatives add no value. Probably because he, too, realizes that they can't remove risk, only transfer it. At a cost.

Volcker then addressed what he feels would work,

"First, let us agree that we have a problem with moral hazard. I do not think that there is any perfect answer in dealing with it, but I would suggest that we can approach an answer by recognizing that elements of finance have always been risky and that's certainly true of the commercial-banking system.

I think we need the commercial banking system for more than automatic teller machines. Commercial banks are still at the heart of the system.

In a crisis, everybody runs back to the commercial banks. They, after all, run the payment system. We cannot have this global economy without commercial banks operating an efficient payment system globally as well as nationally. They provide a depository outlet for individuals and businesses, and they are still big credit providers for small and medium-size businesses, but they backstop most of the big borrowers as well. The commercial-paper market is totally dependent on the commercial banking market. They are an essential financial institution that has historically been protected. It has been protected on one side and regulated on the other side.


I think that it is extraneous to that function that they do hedge funds, equity funds and that they trade in commodities and securities, and a lot of other stuff, which is secondary in terms of direct responsibilities for lenders, borrowers, depositors and all the rest.

There is nothing wrong with any of those activities, but let you nonbank people do it and you can provide fluidity in markets and flexibility. If you fail, you're going to fail, and I am not going to help you, and your stockholders are going to be gone, and your creditors will be at risk, and that is the way that it should be.

How can I be so blithe about making that statement? We need a new institutional arrangement which I believe has a lot of support. We need a resolution facility. What can that resolution facility do? If one of you fails and has systemic risk, then it steps in, takes you over and either liquidates or merges you, but it does not save you. That ought to be a kind of iron cross."


This squares with my own, and my friend B's views. B predicted the evolution to these sorts of Glass-Steagal banks, as a few national banks morphed into today's Chase, Citi and BofA. He noted, as has Volcker, but over ten years ago, that such large deposit gatherers and lenders would need to be restricted from risking that capital in trading, underwriting or other investment banking activities.

The solution we need isn't more complex regulation, so much as a reasoned return to a past regulation, and better, permanent severing of the riskier finance activities from the federally-insured, mainstays of deposit-taking and basic consumer and commercial lending.

More Regulatory Pressure To Separate Commercial & Investment Banking

Way back in 1996, my friend B predicted that, going forward, US banks would become increasingly like utilities, with core lending and deposit-taking functions eventually separated from riskier investment banking. The former would become federally-insured activities, with lending subject to fairly rigorous standards in order to qualify for federal guarantees.

Otherwise, he noted, the few, large deposit-taking banks would subsidize risky investment banking with insured deposits and a "too big to fail" condition that would only lead to increasingly riskier trading and underwriting activities.

This week, Mervyn King, Governor of the Bank of England, and Paul Volcker, former US Fed chairman, once again called for separation of investment and commercial banking. For pretty much the same reasons B prophesied over a decade ago.

Both central bankers identified the increasingly risky behavior of commercial banks which have bulked up proprietary trading and underwriting activities.

Yet, one only has to look at this week's mortgage loan delinquencies at Wells Fargo to see that my old Chase Manhattan boss, Gerry Weiss, was prescient when he observed that money center banks didn't need to enter investment banking to lose money. They could do that in their regular businesses through the usual abandonment of credit standards in pursuit of market share as various product/markets exhibited strong growth in demand.

Is a return to an era of a Glass-Steagall type of separation of investment and commercial banking possible?

If the current administration and Congress have their way, quite possibly.

Given the quick return to risky trading activities at Chase this past quarter, it's clear that the combination of the two types of banking is going to once again, in time, lead to risk-based profits for shareholders and compensation for employees, while heavy losses will once again tax the FDIC and result in federal rescues.

Just a few days ago, on Tuesday, Columbia finance professor Charles Calomiris authored another flawed editorial in the Wall Street Journal, on the subject of universal banks combining investment and commercial banking. The last one one which I posted, here, was exactly a year ago.

Because Calomiris' piece was so long, and contains a number of fallacies, I'll touch on it in a subsequent post.

But, for me, King and Volcker represent far more objective, reasoned positions on the subject of separating riskier banking activities from those of insured deposit-taking institutions.

Volcker v. Kohn On Inflation

Last weekend's exchange between legendary former Federal Reserve Chairman Paul Volcker and current Fed Vice-Chairman Donald Kohn at Vanderbilt University was reported in this piece in the Wall Street Journal.

Any time Paul Volcker weighs in on monetary policy and/or the Fed, I tend to listen. The Journal article reported as follows,

"Former Fed Chairman Volcker, who along with Kohn was at a conference honoring former Fed governor Dewey Daane, questioned how the Fed can talk about both 2% inflation and price stability.

In the minutes of its January policy meeting, the Fed said that officials' long-run inflation forecasts reflect what they think is consistent with the Fed's dual mandate "for promoting price stability and maximum employment."

It then said that "most participants" thought 2% inflation, as measured by the price index for personal consumption expenditures, "would be consistent with the dual mandate."

"I don't get it," Volcker said, leading to a lively back-and-forth between the two central bank heavyweights.

By setting 2% as an inflation objective, the Fed is "telling people in a generation they're going to be losing half their purchasing power," Volcker said. And if 2% is the best inflation rate, and the economic recovery lags, does that mean that 3% becomes the ideal rate, he asked.

Kohn responded that by aiming at 2%, "you have a little more room in nominal interest rates ... to react to an adverse shock to the economy." "

Do the math, and you see Volcker is correct. A 2% inflation rate results in a nearly 50% rise over 20 years. Volcker then asked whether, in difficult economic times, the rate might drift up to 3%? Kohn cited the alleged problem-free experiences of other inflation-targeting central banks as proof that his position is both correct and safe.

It is at this point that I find myself alarmed, as I trust Volcker more than Kohn. And, frankly, don't find other central bank experiences to be quite on a par with that of the US.

But what's really alarming is that this source cites Bloomberg as reporting some additional thoughts of Volckers,

"“I don’t think the political system will tolerate the degree of activity that the Federal Reserve, in conjunction with the Treasury, has taken,” Volcker [said]

... U.S. lawmakers from both political parties have expressed concern in recent months that the central bank has overstepped its authority by creating several emergency credit programs aimed at reviving lending and ending the recession.

“I think for better or for worse we are at a point where the Federal Reserve Act, after all that has been happening in the last year or more, is going to be reviewed,” Volcker said. "

You have to understand Volcker's aversion to Congressional meddling with the Fed. Although, as a Journal article from last year noted, the Fed is a creation of populist forces early in the last century, as the Progressive movement crested with a series of Constitutional amendments in the 1910s, it has notionally and theoretically been independent of Congress.

More than any other Fed chairman, Volcker actively both tamed inflation and fended off Congressional pressure during a period of intense economic pain. It is not an overstatement to claim that, due to Volcker's inflation-fighting prowess and strong resistance to Congress, the US has enjoyed nearly 30 years of low inflation.

That Volcker is now worried about the Fed's independence, thanks to the unnecessary activism under Bernanke and Geithner, worries me. As bad as the Fed's design was, in effect parceling out monetary authority to Fed banks whose presidents are chosen by local banks and businesses across the country, it's far better than allowing Congress direct control over the nation's monetary policy.

Particularly at a time when the federal government is essentially controlled by a single, populist-leaning party. In far less economically stressful times, Congress has threatened to hold hearings, pass legislation and generally exert more direct control over the Fed. For example, we had the senseless 1978 Humphrey-Hawkins bill, the product of a misguided and naive Senator from 'progressive' Minnesota, to thank for diverting Fed attention from simply fighting inflation. Though technically expired, Congress continues to behave toward the Fed as if full employment is an equally-weighted responsibility of the Federal Reserve system, with inflation.

How much worse could it get? I don't even want to go there. But if Volcker's worried, I'm worried.

Volcker's Temperance on Regulation

The Wall Street Journal ran a special section on March 30th resulting from its recent conference on financial regulation. Frankly, I found most of it to be either a rehash of ideas already put forth by others, including myself. There were a few highlights of note. One was Peter Fisher's remarks. Another were some quotes from a discussion including noted hedge fund short James Chanos.

And Paul Volcker's observations on changes in regulation. It is on this topic I wish to write today.

For me, the headline is that, despite being associated with an administration that is rushing about demanding excessive regulation, punitive actions toward private sector executives, and generally attempting to morph our capitalistic system into a fascist one, Volcker enunciates a great deal of common sense.

His remarks begin by focusing on potential changes in the regulatory approach to financial services,

"But beneath the seeming consensus on the broad elements of reform, there is a lot of disagreement. There's a lot of disagreement in principle and even more disagreement in detail. So there is a great kind of political pressure to get things done in a hurry, strike while the iron's hot.

I guess my principal feeling is: Not too fast, because any specific reform raises questions about how it fits into the whole system. And unless you have some idea of the direction in which you want the system to go, it's a little premature to be taking too much specific action.

The other way to look at it, which I favor, is no, there are distinctions that legitimately can and should be made, not only on institutional grounds but on historic grounds and given the present framework we have. And the one is a commercial bank-centered approach, accepting that commercial banks are going to be the core of any system. They've been regulated, they're going to continue to be regulated. We can improve that regulation. Those institutions have a fiduciary responsibility to serve the public, to serve their individual clients, to serve business, to serve governments. That's their job, and they also underlie the infrastructure.

The rest of the system I call a capital-market system. I would not consider them at the core of the system. They might be important, they innovate, they're flexible, but the implication is they don't need to be regulated to the extent of the banking system. Transparency is important. If one of those institutions gets so big they're in some sense systemically important, maybe we have to regulate them with capital requirements. Otherwise, I don't think there should be any presumption that the government is going to rescue them."

I find this astonishing and comforting. Volcker is essentially arguing that we retain our focus on banks, and reinforce with investors that non-bank participants in finance bear risk that will not, despite current federal government actions, be rescued. In this, I think Volcker is correct, and, if influential in the current administration, a tremendous force for slow, sensible changes, if necessary, in regulation.

Volcker then comments on this new notion of a 'systemic risk regulator.' His comments include these,

"Everybody wants a systemic-risk regulator. What is that supposed to do? And what do you mean by systemic risk? Are we talking about a regulator that's going to regulate in detail those institutions? They're going to send in examiners? If so, what do the other banking regulators do? Do they follow the same policies, different policies?

Or do we mean by systemic-risk regulator they're looking for overriding trends in the system that will over time be destructive? Should they have been sensitive to the subprime-mortgage problem and the enormous growth in mortgages, not by looking at individual institutions but by looking at what the market as a whole was producing. Should they have been concerned about an undercapitalization of the banking system generally? That's a different approach than looking at individual institutions.

And what is that systemic-risk regulator supposed to do? What is his charge? Let's not invent the role before we know what the charge should be.

Again, I think Volcker is incredibly astute in calling a spade a spade. Having been involved in my share of risk-related matters while research director at Oliver, Wyman & Co., now the financial services consulting unit of Mercer Management Consulting, I can vouch for Volcker's reticence in tackling this issue.

Whenever I hear government officials begin to babble about 'systemic risk,' I immediately want to ask him/her to define, with equations and variables, precisely what they mean.

Of course they could not. I'm quite sure that even risk management practitioners in most of today's commercial banks and asset management firms could not, either. Or at least not in anything approaching a univocal view of the subject.

Volcker correctly notes this, and even some of the potential conceptual definitions. In this, I think he helps put the brakes on any rush to invent this type of risk, and then regulate it. We are very, very far from such a point, and Volcker wisely says so.

The Journal article which contains Volcker's remarks ends with his thoughts on a few related topics,

Fair-value accounting: That's a big subject that I don't think we're going to solve in the midst of all this turmoil, but it needs careful discussion and determination.

You have this enormous issue of compensation. Well, there is a great urge politically to do something. Most of what the political system would produce is probably destructive, yet there is a real problem of how to deal with compensation policies.

So I hope we take our time to have a kind of consensus on what the general framework of the system ought to be, and what makes sense in individual instances to put into that framework."

Overall, I found Volcker's comments surprising, given his association with the current federal government administration. He seems to be the Volcker of old, who slew the inflation dragon in the late 1970s and early 1980s, speaking clearly, even against prevailing political winds.

I'm pleased to see him providing counsel to government at such a perilous time.