Proprietary Trading and the Volker Rule

In response to this Econmix article by Simon Johnson, a professor of mine wrote a short post expressing surprise that more people are not concerned about proprietary trading, or, what he termed, “gambling.” Indeed, NPR Planet Money had a great podcast a couple of years back entitled Gambling With House Money, which discussed the issue of proprietary trading and its risks and benefits. One benefit is market liquidity. On the issue of “gambling” I agree with Adam Davidson: Banks are always gambling with our money. A loan to a small business is a gamble because the business might fail and the loan might not be paid back. The difference is that proprietary trading often deals with more obscure financial instruments and the risk profile, while modeled with sophisticated statistical techniques, in reality is unknown and therefore invites decisions that might lead to financial loss. Small business loans and mortgages, meanwhile, are well-known entities.

However, I would add that if a bank wants to be a going concern, it always has an incentive to stay in the black over the long-run. Though prop trading can use customer deposits, it often uses corporate profits. To the extent that FDIC insurance covers customer losses, it seems to me that a bank should be able to make whatever bets it wants. The Darwinian nature of capitalism should select for those banks that are prudent.

This, of course, assumes a profit and loss system. But a long history of US government bailouts has called into question how much banks should fear going under (i.e. moral hazard may be a non-trivial factor in risky bank behavior). This gets to the point of too big to fail; Simon Johnson has been the most boisterous voice on this front as the econmix article alluded. Moreover, FDIC insurance negates any incentive customers might have to hold banks accountable. Who cares if my bank fails, I still get my money (and FDIC is paid for with bank fees not taxpayer dollars, doubly nice for me as a consumer). Without such insurance customers would undoubtedly be much more scrupulous about where they put their money and banks would be forced to engage in more conservative investment strategies. The same way that without spell check I would be forced to memorize how to spell ‘scrupulous’.

As far as investment banks go, in his book Bailout Nation, Barry Ritholtz argues that the real problem is the high leverage that large financial institutions enjoyed (he claims levels up to 40-to-1 though the SEC has responded thoughtfully to similar claims). Ritholtz also cites the movement away from partnerships as a primary model for investment institutions.  In other words, banks weren’t just gambling, they were gambling with other people’s money. As Milton Friedman long ago advised, “Very few people spend other people’s money as carefully as the spend their own.”

As far as the Volker Rule, its design will likely lead to poor efficacy in practice. Banks clearly need to be able to hedge specifically so they can protect our money. But the line between a hedge and a speculative bet is fine. So fine that banks will always claim they are hedging even when they aren’t. As always, regulatory capture is a concern.

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