Investment Initiatives » Is Proprietary Trading Essential to Banking Customers?

01.23.10

Is Proprietary Trading Essential to Banking Customers?

Posted in Blog at 2:43 pm

An article contributed by Mike Konczal to the National Review Online, discussed the proposed reform of the banking sector to prohibit commercial banks from engaging in proprietary trading.  The author was generally in favor of such a ban, but quoted the Congressional testimony of Lloyd Blankfein of Goldman Sachs, Jamie Dimon of JPMorganChase, and others, that proprietary trading was a small part of their activities, was a necessary part of their service to clients, and did not create any conflicts of interest.  Such mendacity roused me to submit the following piece to the NRO.

I hate to publicly declare that a major public figure is lying, but as a long-time institutional investor, I must say that Mr. Blankfein and other leaders of the banking industry are at the very least being economical with the truth.  Everyone knows that bankers’ trading desks position themselves against clients, especially when they are sponsoring a major underwriting.  Everyone knows that they cannot trust their stockbrokers and their analysts any more; this is why institutional investors have spent hundreds of millions increasing the size of their in-house analytical staff.

Unfortunately, not only does the creation of such a huge staff dilute the pool of available talent, it also does not ameliorate the problem that such analysts do not have direct access to the marketplace and therefore can only judge the fundamentals of an investment opportunity according to an abstract standard.  In short, Wall Street analysts used to perform an invaluable and irreplaceable function that is no longer being performed because all of the major stockbrokers are now components of integrated investment banks, which earn far more from underwriting new issues than they do from agency broking (which has become a loss-leader).

Then there are the banks’ in-house fund management operations, which have also been known to stuff their clients with securities they would not otherwise have bought, in order to cement a relationship with a corporate client, woo a prospective corporate client, or help out an underwriting that is in trouble.  These are fundamental conflicts of interest, which would inevitably occur even if the organization were somehow able to keep its traders from front-running a major order, or ‘conditioning’ the market in behalf of an especially good broking client (usually a hedge fund nowadays, as these are such a huge source of commissions.)

Next, let’s talk about conflicts that arise from the universal banks’ situation as transfer agents and custodians of securities who often provide stock loans (of clients’ shares, not just their own) to their trading desks both to support their own proprietary trading activities and to facilitate the construction of derivative positions for their hedge fund clients.  They determine the rates paid on securities loans and implicitly, the difficulty any traditionally long customer will experience upon attempting to ‘recall’ the loan (i.e., be bought back in.)

This is before one examines the economic logic of having government-backed entities, using insured deposits, to speculate upon markets, entirely for the benefit of the desk doing the speculating.  Sure, they claim to have ‘Chinese Walls,’ and they even have a few compliance people to try to enforce them.  Any desert nomad who couldn’t figure out how to get through these Chinese Walls doesn’t have the IQ necessary to get a job on the janitorial staff, let alone a responsible position in an investment bank.

When the big Wall Street firms, already riven with conflicts, began to merge with other financial organizations, and later with commercial banks, they always made sales pitches to us as investing institutions, telling us how their increased capital base could be put to work in our behalf as brokerage clients.  They made the same pitch to their corporate clients.  Twenty-five years on, clients are still waiting to find out how this increased capital will help them.  What it has done is to put what used to be a hundred-odd competing organizations in the U.S., and perhaps a thousand world-wide, into an oligopoly of one or two dozen conflict-ridden universal banks so entangled with the ordinary flow of capital around the world that governments must prop up each and every one of them to prevent a melt-down of the entire system.

Risk-taking is a necessary part of any business, and the financial system is no different.  But to claim that those who run the greatest risks must be protected from the consequences of their mistakes by taxpayers the same way that most ordinary, low-risk financial transactions need to be protected flies in the face of every form of logic, as well as three-hundred-odd years of financial experience.

Major risk-takers should be isolated in specialist partnerships, where they gamble only with their own money.  More typical and socially-useful risk-takers (underwriters, insurers—including creators of derivative positions to hedge against risk, fund managers) should probably be herded into distinct organizations where conflicts of interest are less likely, and where the shareholders of the organization alone bear the risk of failure.  Commercial banking, the guardianship of the vast amounts of capital necessary for the ordinary transactions, demand deposits, term loans, and financing of asset-backed transactions, should go back to being the risk-averse activity it traditionally has been.

The providing of electricity, gas, and water to businesses and households long ago ceased to be an exciting activity because it became too essential to our continued survival as a society to allow anyone to have fun manipulating the companies performing these services.  The flow of basic money is no less essential to our continued functioning as a developed society, and should be subject to the same restrictions.

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