Although few know in any detail what the ‘Volcker Rule’ is, everyone who even aspires to hold anything resembling a semi-respectable opinion on The Economy is fully on board with the philosophy behind it, which is that banks shouldn’t engage in ‘prop trading’ or, more generally, ‘risky’ stuff. Here is a typical example, which I cite only as a useful instance of the eminent reasonable-soundingness of the position:
…legislative intent in this legislation is clear…to cut banks down to size and return them to their historical role of intermediating between savers and borrowers. [...] the Volcker Rule directs the regulators to get banks out of the business of betting on the markets.
Hear, hear! you all say. It’s about time! Banks shouldn’t bet on markets. The horror! They should just do the pure and safe and vanilla ‘intermediating between savers and borrowers’ that our grandpas’ banks did.
Being (as far as I can tell) the only person on the entire Internet who doesn’t think ‘prop trading’ should be banned, and therefore is against the Volcker Rule or anything like it lock stock & barrel, allow me to briefly explain what is wrong with the preceding conventional wisdom. Because it is, in fact, a contradiction.
How exactly do banks ‘intermediate’ between savers and borrowers? A saver is someone who wants to make a 1-day loan to a bank. A borrower is someone who wants to borrow 5-, 10- or 30-year money from a bank. How exactly can you ‘intermediate’ between two such people?
The short answer is, ‘you can’t’. The saver and the borrower are not coming to you with truly offsetting positions. So the real answer is, by taking risks.
The above, pure, clean, grandpa-approved banking transaction entails huge risk! What on earth could be more risky than borrowing 1-day money (from the savers) and turning around and lending it out long-term? You’ve all seen It’s A Wonderful Life; what if the savers all come to your teller window at the same time and want their money back? Separately, what if the borrowers’ loans come due and turns out they’re bankrupt? What if the assets the borrowers pledged as collateral (bonds, houses, whatever) suddenly drop in value? What if interest-rates precipitously rise and you suddenly find yourself having to pay savers far more to borrow from them than the average rate you’ve already locked in making all those long-term loans?
If you want banks taking deposits and making loans, then by definition you DO SO want them taking risk. If you don’t want them taking risk, you don’t want banking at all. Modern banking, or no-risk: pick one. The people who complain that banks ‘took risks’ and don’t want them ‘betting on the markets’, yet in the same breath say they should ‘merely’ be focusing on making fractional-reserve maturity-mismatched loans with depositors’ money (!), are either just ignorant or haven’t thought through the situation enough. News flash, all you Conventionally-Wise: LOANS ARE RISKY.
What? Oh, I see, the risk in vanilla lending is ‘understood’ and can be regulated and ‘controlled’ and, like, hedged because we have so much experience with all that sort of thing. Right, I forgot. I guess that’s why all those mortgages (a very, very vanilla and traditional and grandpa-approved type of loan) in the past 10-15 years have all worked out so well and caused no problems for anyone.
Huh? Oh, the mortgages only caused problems because of evil derivatives like mortgage-backed securities and CDS? Um, you do realize that that’s how banks hedged those mortgages, right? If you wanted banks controlling/hedging their risk – and you all sure talk like you do – then CDS was precisely what you were asking for. Similarly, banks can control the risk in their loan portfolios by hedging them – with derivatives. They can hedge the interest-rate risk – with interest-rate swaps (more derivatives). Those derivatives lead to more risk (i.e. counterparty risk), which can be hedged – with more derivatives.
So I could (theoretically) concede this conventional-wisdom notion that grandpa-banking risks can be wisely controlled and hedged, but at the cost of you acknowledging that all sorts of derivatives will need to exist because they play such a crucial role in hedging and spreading the risk inherent in the banking sector. But once we admit that we’ve stepped well away from savers-and-borrowers grandpa-banking and have headed pretty far downfield towards (gasp) ‘prop trading’. After all, the question is no longer whether banks will take risk (they will – loans are risky!), or stick to the ‘good’ sort of grandpa-approved instruments like loans (they won’t – because they can’t – because if they did they wouldn’t be able to control the risks you say you want controlled). The question is simply which risks banks will take, and how much. One way or another, you’ve already conceded that banks will have to be allowed to have desks trading, like, CDS and the CDX.NA.IG credit index and 10-year interest-rate-swaps and suchlike. That desk, whatever it does, will always have taken on some amount of risk or basis. What level of said risk you choose to call ‘prop trading’ is a matter of boring semantics. To borrow from the joke about the high-class lady who protest she’s not a prostitute, we’ve already established that banks will take on risk and therefore (intentionally or not) make bets on the market – we’re just haggling about the amount… That is because at the end of the day there’s no actual ‘bright line’ you can actually draw between ‘good’ risk, and evil ‘prop-trading’ risk. You might think there is, and think that regulators are smart enough to draw it, but you are wrong.
Now, I am just as against private gains/socialized losses as you are. But this ongoing project to micromanage, at the regulatory level, which and how much risk banks can take is an absurd and doomed one. Instead, I am here to say, on the Internet, that we should let banks ‘prop trade’ all they want. BUT, we should also let them fail, if/when they become insolvent doing so.
In fact, if we did that, and credibly, we might find that banks would do a far better job policing their own risk than would regulators sitting in Washington.