The Volcker Principles Move Closer To Practice

By Simon Johnson

Senators Merkley and Levin, with support from colleagues, are proposing legislation that would apply Paul Volcker’s financial reform principles – actually, much more effectively than would the Treasury’s specific proposals.  (Link to the bill’s text.)

Volcker’s original idea, as you may recall, is that financial institutions with government guarantees (implicit or explicit) should not be allowed to engage in reckless risk-taking.  At least in part, that risk-taking takes the form of big banks committing their own capital in various kinds of gambles – whether or not they call this proprietary trading.

At the Senate Banking Committee hearing on this issue in early February, John Reed – former head of Citi – was adamant that a restriction on proprietary trading not only made sense, but was also long overdue.  Gerald Corrigan of Goldman Sachs and Barry Zubrow of JP Morgan Chase expressed strong opposition, which suggests that Paul Volcker is onto something.

Of course, Goldman – among others – may seek to turn in its (recently acquired) banking license and go back to being “just an investment bank”, not subject to Fed regulation.  But raising this possibility is a feature, not a bug of the Volcker-Merkley-Levin approach.

Think through this logic – which I argued out with a very senior ex-Goldman person this weekend.

1)      If Goldman wants to be saved in the future, it needs to be subject to tough regulation – including this new restriction on proprietary trading.

2)      If it doesn’t want to be saved, that works for me.  But there is no way that Goldman at its current scale – or anything near – could fail without causing enormous collateral damage (literally).  Remember that there is no prospect of a “resolution authority” that will work for cross-border financial institutions, like Goldman (in private, top officials and leading bankers are willing to concede this).

3)      So if Goldman wants to escape the Volcker Rule, it will have to become much smaller.

4)      How small is open to discussion – but I would guess that this would be no larger than Goldman’s size in 1998 (around $270 billion in today’s dollars).  Given what we’ve learned about the limitations of everyone’s internal risk models, a sensible regulator would probably want to be even more conservative on size.

5)      My assessment is that if Goldman were around $100 billion in total assets, that would be a reasonable outcome – although we still have to worry about what they (or anyone) does in the “dark markets” of over-the-counter derivatives.

In any case, putting these issues openly on the table for Senate Banking – and on the floor of the entire Senate – is incredibly helpful.  The Volcker-Merkley-Levin proposal is concrete and feasible, and a useful part of how we can move forward.

29 responses to “The Volcker Principles Move Closer To Practice

  1. I love the idea of Goldman turning in its banking license because it will hamper their profitability. It’s like a get-out-of-jail free card. When things are going against you, take the license on, in record time, no less, breaking all rules and precedents to make it happen in 2 days. Then when the climate improves, turn the license back in because you don’t like the way that security hurts your profitability. Also, you don’t have to worry about anything, because if things get ugly again you can always reclaim the license and govt support.

    What a deal!

  2. Just make sure they repay the 21bn in FDIC-backed debt on the way out. Oh not so fast, let’s have one more for the road! No shame with these guys.

    http://wallstreetpit.com/18165-goldman-plans-on-selling-2b-in-fdic-backed-bonds

    http://www.zerohedge.com/article/proposal-goldman-sachs-pay-down-212-billion-tlgp-borrowings-using-your-20-billion-bonus-accr

  3. Maybe we will get lucky and the next crisis will start before everyone forgets about the current one.

  4. You think if prop trading and internal hedge funds/PE were banned, Goldman would have to shrink from ~$900bn to $270bn?

    Please tell me that’s a joke.

    That’s so delusional I don’t even know where to begin. Goldman’s internal hedge funds only have roughly $20bn in assets. The vast majority of Goldman’s trading profits come from market-making in flow products (e.g., interest-rate swaps, commodity futures), NOT prop trading. Market-making, which is explicitly excluded from the Volcker Rule, is a very asset-intensive business — hence the large balance sheet. To lump market-making and prop trading together betrays a fundamental ignorance of financial institutions (not to mention capital markets).

    FAIL.

  5. I like the idea of shrinking money centers by siphoning off capital for a bailout fund. It’s like enforcing higher capital ratios, but it is immune to off balance sheet tricks that make the capital position look better than it really is. The funds have been written into the House bill ($150 bil) and some versions of Senate bills ($50 bil), but they probably need to be bigger.

    Relinquishing Federal charters should not exempt any firm from contributing to the fund.

  6. Fail? You mean as in flunked?

  7. Groundhogday

    I think you need to read more carefully. Simon did not say that Goldman would shrink to $270bn due to the elimination of proprietary trading. He said that they SHOULD be forced to shrink to $270bn (or less) via regulatory intervention should they give up bank holding status… something they might do to AVOID giving up proprietary trading activities.

  8. None of them is going to voluntarily give up access to the Fed discount window.

    Just ain’t gonna happen.

  9. A move of which in itself would constitute a systemic threat to the global economy.

  10. Also, we should be spending MUCH MUCH more of our time talking about how to define “banks”, who should have access to the Fed, and how big is too big.

    There used to be a very strict definition of “bank”, but that has gone out the window. Going forward, how do we decide who gets support? Think about GE, GM, Chrysler, etc. MS owns a half-built casino in Atlantic City. Goldman is one of the largest hotel operators in the world. Should the government be backstopping these activities?

    This is a very big part of figuring out how to approach the problem, which at heart is the rent-seeking that we’ve seen (for decades if not centuries) from large and influential corporations. Look at the oligarchs in Mexico and Russia for examples of what can happen if we don’t ringfence certain business activities.

  11. markets.aurelius

    Does pump-and-dump rip-your-face-off asymmetric information exploitation count as prop trading?

    http://www.bloomberg.com/apps/news?pid=20601087&sid=ax3yON_uNe7I

  12. markets.aurelius

    Just to be clear, the exploitee is the taxpayer (re above link), not AIG. AIG was the conduit (funnel) in this one used by the exploiter. (Whatever else might be said, it was brilliant how GS got itself paid. Every lever pulled, every button pushed. Brilliant.)

  13. To give up its BHC status, Goldman would just have to sell its commercial bank subsidiary, which only has roughly $90 billion in assets. That would bring them down to roughly $800 billion in assets — $530 billion more than Simon claimed.

    Either way, Simon is completely wrong, by a long shot. Par for the course anymore — Simon’s a total nutjob now.

  14. What he’s saying is a hysterical over reaction – that a non-bank should be limited to around 270 billion in total assets. So split GS into thirds if it gives up BHC status.

  15. markets.aurelius

    If they’ll doing “commodity futures” they’d best be ending up on the floor of the commodity exchanges, smart guy. Otherwise, they’re running a bucket shop, which is illegal. (Go research that one, huh, so that in your next reply you actually sound like you have a clue.)

  16. Master of None:

    You got it totally backwards. In Russia there is a massive fence around business activities and in America those activities are comparatively free. http://www.starvethemachine.net

  17. Mr. Johnson wrote:

    “My assessment is that if Goldman were around $100 billion in total assets, that would be a reasonable outcome – although we still have to worry about what they (or anyone) does in the “dark markets” of over-the-counter derivatives.”

    Dark Matter

    ScienceDaily (Nov. 3, 2009) DOE/SLAC National Accelerator Laboratory – excerpt

    “….confirming that dark matter and dark energy make up 95% of everything in existence, while ordinary matter makes up just 5%.”

    http://www.sciencedaily.com/releases/2009/11/091102121644.htm

    In financial physics, it is suggested that dark markets/pools and their financial instruments, may occupy more than 50% of the financial universe. It’s all too much for my pea-sized brain.

  18. You must admit this is sheer genius. The gov’t is legislating away its discretion to bail out TBTF entities. Sheer genius.

  19. “financial institutions with government guarantees (implicit or explicit) should not be allowed to engage in reckless risk-taking”

    Please define reckless risk-taking for us. The reckless risk-taking that brought us this crisis was following the credit rating agencies appointed by the regulators to decide on the capital of the banks. If society is going to guarantee even the smallest risk-taking is it not to suppose that serves a purpose? Some would even love banks to engage in reckless risk-taking if that helped to alleviate energy and climate change restrictions on growth.

  20. How about this for one of the rules. No federally insured bank would be permitted to trade in derivatives for their own account unless they were traded on an exchange.

  21. I never said Goldman’s commodity futures weren’t being executed on exchanges, “smart guy.” I said Goldman was a market-maker in derivatives like commodity futures, which is true. (Exchange-traded derivatives rely on market-makers too, buddy.)

    Seriously, learn to read.

  22. I think in order to limit the size of the financial sector OMO’s should be conducted directly with the citizens and not financial institutions. All new funds that enter citizens accounts should be registered as debt either.

  23. I think in order to limit the size of the financial sector OMO’s should be conducted directly with the citizens and not financial institutions. All new funds that enter citizens accounts should be not registered as debt either.

  24. Guaranteed that GS attorneys are, as we speak and read, burning the midnight oil finding loopholes to climb through. Sad to say, but the “haves” have enough assets to buy solutions, always have, always will. But, I won’t argue that this is a start. But, why not just reinstitute Glass-Steagall, since it really serves the same basis. The fact that this new law might force GS to give up real banking, not a core business and only used by them to graze for cheap dollars to tie up in their derivatives and other “dark” projects, is living proof that the new law is an echo of Glass Steagall. A good start would be to repeal Gramm-Leach and see what happens then.

  25. “Concrete, feasible” and DOA. Ain’t gonna happen. No way.

  26. you are delusional if you think goldman is making huge spreads on just their market making activities. This is a commodity ( no pun intended) activity so that if what you are saying was true either there would be hundreds of others doing it or they are just ripping off their clients.

  27. Of course, off balance sheet activities will have to be severly limited, also. And a strong independent regulator will need to be in place to limit Goldmans inevitable end run efforts. Not to mention substantially beefed up capital requirements.

  28. There’s no point where the original post says “IF GS gave up its bank and prop trading, it WOULD be be $270B.” I don’t see how you can read it that way. It says “I think $270B might be a size at which an individual broker-dealer could be saved in case of failure.” GS couldn’t reduce its balance sheet that much, which means it would have to be broken up. Maybe by asset class?

  29. “Think through this logic,” says Simon Johnson, “1) If Goldman wants to be saved in the future, it needs to be subject to tough regulation – including this new restriction on proprietary trading.”

    –No, it needs to be big and politically connected.

    Then Johnson concedes that Goldman is too big to fail at its current size. From this he infers, “3)So if Goldman wants to escape the Volcker Rule, it will have to become much smaller.”

    No, if Goldman wants to escape the Volcker rule it will exercise its political influence either to scuttle the Volcker rule or to exploit the loopholes already in the rule. (Volcker’s own 1/31/10 NY Times op ed revealed that he had no clear definition of the proprietary trade to be “limit[ed]” {not banned} and that the alleged cap on bank size was equally undefined.)

    Time will settle this little dispute concerning the political economy of corporate capitalism.