More Details

The financial reform bill that passed the House recently is full of surprises, not all of them bad. A contact pointed me toward an amendment introduced in committee by Brad Miler and Ed Perlmutter; it’s number 61 on this list. Basically, the amendment gives the Federal Reserve (“Board” in the text refers to the Board of Governors of the Fed) the power to prohibit a financial institution from engaging in proprietary trading not only if it decides that proprietary trading threatens of the soundness of the institution itself, but also if the Board of Governors decides that it threatens the financial stability of the country.

While this may seem overzealous, the point is to prevent a large financial institution with a government guarantee (of any kind) from putting most of its capital to work on its proprietary trading desks and taking lots of risks that might require a government bailout. The amendment does have exceptions allowing firms to, for example, make a market in securities that they underwrite, so securities underwriting is not in question here.

The amendment was inspired by Paul Volcker’s testimony back in September, when he said:

“As a general matter, I would exclude from commercial banking institutions, which are potential beneficiaries of official (i.e., taxpayer) financial support, certain risky activities entirely suitable for our capital markets.  Ownership or sponsorship of hedge funds and private equity funds should be among those prohibited activities. So should in my view a heavy volume of proprietary trading with its inherent risks. Some trading, it is reasonably argued, is necessary as part of a full service customer relationship.  The distinction between ‘proprietary’ and ‘customer-related’ may be cloudy at the border. But surely by the active use of capital requirements and the exercise of supervisory authority, appropriate restraint can be maintained.”

Since the effective repeal of Glass-Steagall, no such prohibitions exist. The usual justification for proprietary trading is that it provides liquidity and pricing efficiency to markets; the comeback is that that’s the job of hedge funds (which are both un-regulated and un-guaranteed), not Bank of America. A related justification is that if a bank is providing trades to nonfinancial customers, it is likely to take on positions that cannot be perfectly hedged, and suddenly it is engaged in proprietary trading, like it or not; but here it seems like an effective regulator should be able to tell the difference between imperfect hedging and big one-way bets.

So the real question is: Does the fact that Goldman Sachs (for example) makes a big pile of money in proprietary trading provide some corresponding benefit to its customers? Or is it simply that Goldman is so good mining its customers for market information (as discussed in this article much better known for the “God’s work” quote) that it would be a shame for it not to make a big pile trading on that information?

In any case, there remains the issue of whether the Senate bill will include similar language, and whether the Fed would have the backbone to use this power when the need presented itself. But it’s better to have the tool there than not to have it.

By James Kwak

19 responses to “More Details

  1. It may be good to have the tool there – but it’s hard to imagine the Fed telling GS or any of the other large Wall Street firms that they can’t engage in prop trading because they believe the firm to be taking on more risk than it should.
    This is the kind of judgment that emerges after an accident has taken place and not as an act of foresight and prudent risk management

  2. Just re-instate an updated version of Glass-Steagall and be done with it. Stop tip toeing around the issue.

  3. If they were serious about reform they’d reinstate Glass-Steagal or, better yet, relegate all gambling to the non-legal underworld where it belongs.

    I suppose giving the Fed this theoretical power might not hurt, or maybe it will if it’s used to justify no further action. (In Massachusetts vs. EPA the Bush admin argued that EPA could not regulate carbon or, at the very least, that it be optional. Of course they intended to never do it at all. Just like here. Just like this predatory health racketeering bill will be used to stave off any real action in the future.)

  4. I fully agree with morph and ruetheday.

    James: ¨ [1] In any case, there remains the issue of whether the Senate bill will include similar language, and [ 2] whether the Fed would have the backbone to use this power when the need presented itself. [3] But it’s better to have the tool there than not to have it.¨

    ad 1: We do not need bills of hundreds of pages with all kinds of exemptions.
    Lack of transparency is one of the root causes of the crisis, and bills of hundreds of pages with complicated, legalistic exemptions are a symptom of lack of transparancy.

    ad 2: clearly, the FED does not have that backbone. Look, regulators already have powers; but… they did not use them ( a point William Black keeps hammering on; BTW, another point Black keeps hammering on: in his days at S&L debacle 1000+ fraudsters were indicted, whereas now only 1).

    ad 3: I disagree. A tool not used is worse than no tool, as it gives the false impression of security.

    Reinstate the Glass Steagall act: it worked fine for 70 years; within 8 years of its removal we got a crisis.
    Undo the Commodities Futures ¨Modernization¨ act (outlaw CDS, CDO, CDO-squared and other speculative gambles).

    P.S. Lately Paul Volcker uses much clearer language than in that quote from the September hearing. Full separation of saving deposits / lending banking from trading, i.e. he wants Glass Steagall back.

  5. “But it’s better to have the tool there than not to have it.”

    Disagree completely.

    Having it there and not using it (let’s be honest, we all know the Fed would NEVER grow a backbone sufficient to slap a C&D on Goldman) has the indirect consequence of endorsing all trading activities by IBs. The complacency this creates over time is extremely destabilizing.

    I’d rather the market be perpetually terrified at the prospects of systemic risk than be told by bankers that their friends are acting responsibly.

  6. But they are clearly NOT terrified of systemic risk

  7. More meaningless crap?

    Tell us again – who is the “Fed” and who do they work for?

  8. Very nice amendment, but it means nothing, and is in fact, dangerous.
    As Taleb has pointed out, when finance people, risk managers and other intellectual frauds say it’s better to have a number quantifying risk, than not to have a number, this amendment will only quiet fears that should not be quieted. That is, the amendment will provide a false sense of security similar to that provided by VAR and other nonsense.
    I would really like to see baselinescenario.com get 100% in support of re-imposing Glass-Steagal. You guys have a lot of influence and I think it would help Mr. Volcker and others a lot if you spoke out very loudly and consistently in favor.

  9. chas, thanks for the link.
    but it contained some errors, a.o.:

    “It [the FED] also has come under pressure from politicians seeking greater oversight of its primary job, adjusting interest rates to moderate economic growth.”

    This is fear mongering from the Fed and banksters. The ‘audit the fed’ bill states that it does NOT want to interfere with interest rate setting decisions. Fed and banksters continue this lie to prevent the audit bill from passing.

    The required oversight is for an audit of the Fed’s balance sheet: who was given how much (par?!) money for what toxicities?

    +
    “Alan Greenspan, said that banking was becoming too complicated for regulators to keep up. As he put it bluntly in 1994, self-regulation was increasingly necessary “largely because government regulators cannot do that job.” ”

    I’d thought that Greedscam was pro self-regulation on principle (Ayn Randish), but now it appears even back in 1994 these behemoths were already too big to regulate!!

  10. Agreed. This is the core issue. Do it now, or do it after the next bubble burst. Putting depositor’s money into a gambling casino deserves an explanation as to why we are doing that.

  11. I get 404 on the “God’s work” article link – anybody has a working link?

  12. I would change a bit to relegate all gambling to legal casinos, and off track betting shops (generalized). Then at least you can tax it! (Rather than spending tax dollars to police it, and/or corrupting law enforcement)

  13. That is pure BS. The Bernanke led Fed will never use it. Glass-Steagall is the only answer. I certainly agree with the sentiment, but working (tiptoeing as someone said) around the edges just doesn’t do it. It’s like saying to Goldman, et al, “don’t do that” and expecting them to listen and heed. You can’t drive nails courteously, but with an appropriate hammer, and I’m afraid that this version of a hammer is made of marshmallow. Unless we decide to seriouslly regulate, all is going to be lost, period!!!

  14. Thank you for the details!