Proprietary Trading and Financial Reform

Posted in Blog at 2:36 pm

The following was written in response to an article by Martin Wolf in the Financial Times, “Volcker’s axe is not enough to cut banks to size,” on January 26th, 2010, questioning the viability of the Volcker proposals to prohibit commercial banks from engaging in proprietary trading.  In particular, Mr Wolf wondered whether it would be possible to distinguish between transactions carried out on behalf of clients, and those done with the bank as principal, for its own profit.

Is it really necessary for banks to assume so much risk on behalf of their clients that the hedging of said risk would constitute such a large portion of their activity as to permit them to hide proprietary trading within it? In my experience, a great deal of what banks do for clients is (a) immediately sterilized, or (b) laid off upon other clients, or (c) grossly exaggerated. Banks don’t “risk” much on behalf of clients, although they may speculate in parallel with them, or even against them.

One also must question the wisdom of a financial system in which a financial intermediary is called upon to assume on its own risks better borne by a corporate issuer or bidder, or by natural investors in the market, such as pension funds, mutual funds, hedge funds, and insurance companies. If buying a deal was necessary in order to land the business, perhaps that indicated that there was too much investment banking capacity chasing too few corporate deals; more likely, it was because the banks had figured out how to make larger profits by acting as principals, i.e. engaging in proprietary dealings of one sort or another.

Now that we have figured out that such proprietary activity is dangerous to the stability of the whole financial system, we ought to be able to go back to syndicating much of the risk through the marketplace, using properly registered standardized instruments, cleared through an organized market, rather than relying upon impromptu over-the-counter creations and ad hoc agreements which can create enormous hidden risks in an invisible marketplace. Similarly, it seems to me that much of the shadow banking sector is composed of organizations having their own specialized mandates that should mitigate against their being abused by serving as tools for some unrelated dealing for their own account—at least if they were being properly regulated. Of course, this would mean that such organizations could also not be controlled by deposit-taking banks. But why would that be a problem, except to empire-builders within the banking sector?

Comments are closed.