By Simon Johnson
A powerful new voice for financial reform emerged this week – Sarah Bloom Raskin, a governor of the Federal Reserve System. In a speech on Tuesday, she laid out a clear and compelling vision for why the financial system should focus on providing old-fashioned but essential intermediation between savers and borrowers in the nonfinancial sector.
Sadly, she also explained that she is a dissenting voice within the Board of Governors on an essential piece of financial reform, the Volcker Rule. Her colleagues, according to Ms. Raskin, supported a proposed rule that is weaker, i.e., more favorable to the banks; she voted against it in October.
At least on this dimension, financial reform is not fully on track.
Two years after the passage of the landmark Dodd-Frank financial reform legislation, you might imagine that the crucial detailed regulations would already be in place.
But, not so, at least with regard to the Volcker Rule, which is intended to limit the ability of big banks to make large “proprietary” bets. (Proprietary trading is jargon for speculation – betting on asset prices going up and down.)
The basic idea of this is simple and completely compelling. Paul A. Volcker, the former chairman of the Federal Reserve System, has stressed that this measure will help us move away from an arrangement in which the people who run big banks get the upside when they are lucky – and the rest of us are stuck with some enormous, awful bill when things go awry. Senators Jeff Merkley, Democrat of Oregon, and Carl Levin, Democrat of Michigan, fought long and hard to get meaningful provisions into the legislation. But these still need to be turned into regulations that must be followed.
The final Volcker Rule was due out last week but did not appear. The current expectation is that it will appear at some point in August. (The Fed is one of five regulators involved in setting the Volcker Rule; the others are the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Securities and Exchange Commission.)
As Ms. Raskin explained in her speech, “I view proprietary trading as an activity of low or no real economic value that should not be part of any banking model that has an implicit government backstop.”
Our largest financial institutions are bank holding companies, which include both banks and enormous trading operations. These activities are intermingled deliberately by bank management – and typically with the approval of regulators.
In a recent study released by the Federal Reserve Bank of New York, Dafna Avraham, Patricia Selvaggi and James Vickery found that legal and organizational complexity – for example, measured by total number of corporations within a single global financial institution (think Citigroup or JPMorgan Chase) – has increased greatly in recent years.
These structures are intended to benefit from association with federally guaranteed deposits as well as the broader but more nebulous protection that comes from being perceived – by officials and by markets – as too big to fail. A commercial bank gives trading operations huge financing advantages, in part because they have the implied backing of depositors and taxpayers; this is why so many banks have put their enormous derivatives trading operations in their insured banks.
Goldman Sachs this week announced that it will expand its regulated bank as a way to obtain lower-cost financing. The federal insurance on deposits is a great deal for a high-risk trading operation like Goldman’s, lowering its financing costs by perhaps 200 basis points (two percentage points, an enormous amount in today’s markets).
Without government guarantees, creditors to Goldman would want to be compensated for the risks they are taking. As things now stand, Goldman is receiving a large implicit government – and taxpayer – subsidy. The same is true at all the other large banks.
Marc Jarsulic of Better Markets points out that, during the height of the financial crisis, the largest financial institutions in the country received a great deal of emergency financing to support their securities operations. At its peak in September 2008, this financing amounted to around $430 billion (per day).
Like it or not, our “banks” have become securities trading operations. (For more on this and all other dimensions of the Volcker Rule, see Better Markets’ “Everything You Need to Know About the Volcker Rule.”)
Even Sanford I. Weill, former head of Citigroup – and a previous proponent of “financial supermarkets” – now thinks megabanks should be broken up. He told CNBC’s “Squawk Box” on Wednesday:
“What we should probably do is go and split up investment banking from banking, have banks be deposit takers, have banks make commercial loans and real estate loans, have banks do something that’s not going to risk the taxpayer dollars, that’s not too big to fail.”
What these people are converging on is the view that allowing megabanks with their current scale and scope to speculate makes no sense at all.
Unfortunately, we are all learning that just passing a tough law isn’t enough. Regulators must enforce it. Sadly, it seems that our regulators are likely to implement a Volcker Rule with loopholes that may still allow mega-banks to gamble excessively. On the precise nature of these loopholes, see two very powerful comment letters, from Occupy the S.E.C. and Senators Merkley and Levin.
From the tone and timing of Ms. Raskin’s speech, we can reasonably infer that the loopholes remain a big issue. Ms. Raskin uses the metaphor of guard rails on roads: “I was concerned that the guard rails as crafted could be subject to significant abuse – abuse that would be very hard for even the best supervisors to catch.”
Financial institutions know when they are engaged in proprietary trading, but they can hide it well.
The loss-making JPMorgan Chase trading operation in London was headed by Achilles Macris, a well-known proprietary trader renowned for taking risks.
You do not hire a proprietary trader to run a tame hedging operation; you hire him to gamble. You don’t buy a race car to park it in the garage. And when you race it, you have to be prepared for the inevitable crash.
JPMorgan Chase has still not disclosed the structure of its compensation arrangements in its London office, but the likelihood is that compensation must have been in line with standard proprietary trading compensation.
The best way to prevent proprietary trading – as suggested by Better Markets – would be to tie compensation within the securities subsidiaries of bank holding companies to fees for services and trade-flow commissions. Do not pay traders based on their profit and loss on particular positions, irrespective of whether they or anyone else call that proprietary trading.
This and other meaningful restrictions are not likely to be imposed, at least if Ms. Raskin’s concerns about her colleagues are justified.
More serious problems with global megabanks are heading our way.
This column appeared on Thursday on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.