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