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Barry Ritholtz on the Volcker Rule:
There has been enormous pushback against what should be a simple piece of prophylactic rules on proprietary trading by depository banks… Why?
Well as you know, my answer is very simple: “proprietary trading” (in the sense of an objectively identifiable type of trading that you can cleanly and neatly and easily separate and segregate from the other kind) does not exist. Hence any effort to ban “proprietary trading” – again, an activity with no clear, unambiguous definition – will inevitably result in a sprawling, opaque piece of spaghetti regulation designed (but in a doomed way) to plug all ‘loopholes’ and cover all special cases anyone can think of. And with so many moving parts, and so many arbitrary definitions and proscriptions and reporting rules (inevitably) embedded in such a regulation, it is bound to rub up against the real world in unfortunate and unhelpful ways, i.e. by accidentally banning or obstructing stuff that, in actuality, is just fine. Thereby screwing the pooch for no good reason.
When the private sector and citizenry sees the government screwing the pooch for no good reason, of course they will push back. What would you have them do?
Ritholtz seems to think that merely because you can state the principle in an easy and (he thinks) unobjectionable way – “don’t prop trade” – that ought to translate automatically to a clear and good regulation to which no one could possibly object. Merely to restate such a belief is to illustrate its folly. And it would be folly even if “prop trading” were like an actual, clearly-defined thing to be banning. Since it is not, the problems are only multiplied exponentially.
He then launches into a discussion of MF Global as a purported illustration of something (“Think MFGlobal to get a better understanding of what is involved.”). I confess to being hugely perplexed at people continually trotting out MF Global in discussions of the Volcker Rule (“banks, no prop trading!”) and Glass-Steagall (“no mixing of commercial and investment banks”). Um guys, MF Global was not a bank.
I am glad however that Ritholtz realizes that loans are risky and that all of plain-vanilla banking, contrary to popular belief that it is riskless ‘intermediation’, intrinsically contains huge embedded risk:
Fractional reserve banking means that the $100 you deposit is lent out — only $10 of your $100 is kept in reserve. …. you merely have a claim on those monies, and that claim is insured by the FDIC, and backed by taxpayers (theoretically).
You are, in fact, a counter-party to your bank.
Exactamundo! The main difference between he and myself on this point is that he, seemingly, just realized all this. But the truly important difference is that he thinks that banning “prop trading” is somehow an important bulwark against the inherent riskiness of banking and its susceptibility to bank runs.
At this point I just have one question for people like Ritholtz to whom banning “prop trading” is somehow so important. As you recall, banks were taking 9- and 10-figure writedowns on mortgage securities and CDOs in 2007-2008; that is, I presume, what you are all reacting to and the sort of thing you are trying to avoid. My question: do you think they got into those positions primarily via “prop trading”?
UPDATE: Some comments there are instructive.
S J Morton Says:
February 15th, 2012 at 9:20 am
Sure, it’s all well and good to insulate depositors from the risks of proprietary bank trading, except:
–Prop trading had absolutely nothing to do with the financial crisis. Zero. The financial crisis was caused by credit problems, and prop desks are far too nimble to get hooked on illiquid nuclear waste.
–Now that the investment banks are gone, only commercial banks are left to provide market-making liquidity. If you take away that activity from them, liquidity will drop sharply, no way around it.
–The Volcker Rule attempts to allow banks to make markets without any residual trading risk through a layer of bureaucracy so deep that the consultants are having a field day sorting it out. The rules are unworkable, and will drive the banks out of the market-making business.
(emph. mine) – Finally! – someone else sees what I see. Of course these are all points I make regularly.
Regarding prop trading – not all banks were similar. Read the UBS report. The prop desk was early to the game and got out sort of early and with smallish 2-3 billion loss. The flow CDO desk was responsible for the big 10s of billions losses.
Bingo. My closing question above is answered correctly. Those big writedowns and losses you heard about did not come primarily from ‘prop trades’. Someone tell Barry Ritholtz, Paul Volcker, et al. How did we get to the point where the VAST majority of bank losses came on ‘market-making’ (that is what ‘flow’ means there) and yet the agreed, conventional-wisdom Smart solution is to ban ‘prop trading’?
Finally a representative comment from the dissenting side to myself:
February 15th, 2012 at 10:11 am
@S J Morton;
Liquidity will not drop sharply but it will be forced to come out of entities that are not FDIC insured and backed by tax-payers. [...] We want independent brokers that are not banks to become more competitive and take away the gambling business from FDIC insured institutions.
Oh, I see! So we need not worry about liquidity because the intent is just to push a lot of liquidity and market-making function into ‘entities that are not FDIC insured’ and ‘independent brokers’.
You know, like MF Global!
Hmm hold on. Wasn’t the experience of MF Global supposed to be Exhibit A as to why we need the Volcker Rule? And yet the intent of the Volcker Rule is to push activity away from banks and into an army of MF Globals? MF Global failed, and that was terrible, therefore we want to push more of peoples’ risk into the MF Globals of the world?
Sorry I know I’m not Smart (only 28% Smart) but this really does not make any sense to me.
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