Want a Rerun of the 2008 Crisis? Let Banks Gut the Volcker Rule
Bankers are trying to gut the Volcker Rule, part of last year's Dodd-Frank financial-reform law that would curtail banks' ability to make trades for their own profit. Volcker is the most important financial reform to come out of the mortgage meltdown, and without it nothing will change.
The rule is named after former Fed chairman Paul Volcker. He has frequently criticized trading by banks for their own profit, known as proprietary trading, for encouraging them to take excessive risks. Prop trading also creates a huge conflict of interest, because financial institutions started betting against their clients with information the clients had provided for their own trades.
Instead of arguing either of these points, financial folks are trying to expand an exemption to the rule that would effectively render the regulation meaningless. That exemption has to do with "hedging" -- trades designed to offset risk taken by a bank, usually on behalf of customers.
This hedgehog knows nothing
Hedging was originally defined narrowly to mean trades tied to specific bets. The latest draft of the rule -- scheduled to go into effect next month -- uses a very broad definition of risk. Now it is to be judged on a broader portfolio basis including "the aggregate risk of one or more trading desks." That would allow banks to define risk so broadly -- as in, say, the risk of a global recession -- that they could do anything. As one former president said, "It depends on what the meaning of the word 'is' is."
Would this cause a repeat of the mistakes that lead to the financial crisis? You betcha.
According to a report from the Government Accounting Office, the six largest U.S. bank holding companies collectively derived $15.6 billion in revenue from proprietary trading between June 2006 and December 2010. That's around 3 percent of total revenue. Those trading activities wound up costing the banks $221 million over that period, due to a combined $15.8 billion in losses during the financial crisis.
That is a misleadingly low figure as it only accounts for losses from the proprietary trading desks. The information gathered by the company from its clients was used by other desks to make other trades. How much that cost we will never know. The GAO investigators said that because of a lack of separate records it was "not feasible" to collect similar information from other bank divisions.
Conflict zone
The importance of the Volcker Rule lies on the ethical front as much as anything else. As Jeremy Grantham, co-founder and director of the investment management firm GMO, wrote:
Proprietary trading by banks has become by degrees over recent years an egregious conflict of interest with their clients. Most if not all banks that prop trade now gather information from their institutional clients and exploit it. In complete contrast, 30 years ago, Goldman Sachs (GS), for example, would never, ever have traded against its clients. How quaint that scrupulousness now seems. Indeed, from, say, 1935 to 1980, any banker who suggested such behavior would have been fired as both unprincipled and a threat to the partners' money.Grantham does not pick Goldman at random. Until 1980 it was a company built around putting the clients' interests first. That changed. As Joe Nocera and Bethany McClean point out in their great history of the meltdown All The Devils Are Here:
In the aftermath of the crisis Goldman would be excoriated by the press and the public, and investigated by Congress, the SEC and the Justice Department, for the way it used synthetic mortgage-backed securities to advance its own interests; often at the expense of its clients.Certainly there are flaws with the Volcker Rule. It expects regulators to rely far too heavily on value-at-risk (VAR) when gauging exposure. Goldman -- the industry's geniuses of risk management -- views VAR as a starting point, not a full picture metric.
But that is a minor point. Volcker is the most important part of the Frank-Dodd reforms. It is this generation's version of the 1933 Glass-Steagel Act, which prohibited a bank holding company from owning other financial companies. Its repeal in 1999 all but assured we would end up where we are today. The Volcker Rule is as close as we're going to come to resurrecting it.
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