RIP Prop Desks
The Volcker Rule and its legislative translation
August 26, 2010
It used to be that Alan Greenspan was a rock star in the investment universe. After all, he did preside over the longest economic expansion in U.S. history. Lots of fans have lately unfriended Greenspan – though he still commands top dollar as a speaker. Partially, it’s based on the minutiae of reckless consumer mortgage behaviour, where Greenspan and his FOMC colleagues were supposed to have said to aspiring homeowners: “don’t buy; rent and invest the difference,” and then whacked them with an interest rate increase. Or rather whacked their improvident bankers.
More thoughtfully, critics have decried Greenspan’s belief in financial innovation. Or more properly, financial innovation as an intrinsically self-regulating process. Securitization, by itself, need not be harmful – any more than government deficits should be considered harmful – as long as consenting adults know what they’re doing.
But the fallout from the Great Financial Crunch suggests otherwise. Consenting adults didn’t have a clue what they were doing: too many people took too many risks because there were too few rules to prevent them from gaming the system.
In steps Paul Volcker, Greenspan’s predecessor at the Federal Reserve. He proposed a basic rule to prevent proprietary trading by banks as well as side investments in hedge funds and private equity deals. It was, after all, the proprietary traders, making bets on CDOs and CDSs, among other bankster activity, that bankrupted Bear Stearns and Lehman Brothers.
Stopping prop desk traders from playing Russian roulette with borrowed bank capital is not so easy, it turns out.
Former IMF chief research counsellor Simon Johnson notes (with a clever title, “The Treasury Position,” which recalls ‘The Treasury View” – the 1930s bureaucratic opposition to Keynes):
“Senators Carl Levin of Michigan and Jeff Merkley of Oregon, after considerable effort, were able to place strong language in the Dodd-Frank financial-sector legislation – enacting a version of the “Volcker Rule” that would require big banks to become significantly less risky. While this idea originated with Paul Volcker … it was clear – from the beginning and throughout the detailed negotiations this spring – that the Treasury Department was less than fully enthusiastic about this approach.”
What does the Volcker rule involve? “Reducing conflicts of interest, limiting proprietary trading and ensuring that market-making doesn’t become a hidden way for banks to take huge risks.”
Adds Johnson: “[I]n the Treasury interpretation big banks would be allowed to rearrange their activities so they can still effectively take big risks – earning big returns in good times and creating major problems for the rest of us when the cycle next turns down. Mr. Geithner is insisting, as he did throughout the Congressional negotiations, that all the weight should be placed on increasing capital and improving its quality. This is not objectionable as one element of a reform strategy, but it still looks very much like putting all our eggs in one dubious basket – one that has failed us repeatedly before.”
Does all of this matter? For Johnson, yes. It’s not a theoretical discussion.
“Given this context, we should worry and wonder about the “financial innovation” to which the secretary alludes. Again, this sounds good in principle, but in practice the benefits are elusive, if not illusory – other than for people in privileged positions within the financial sector. Mr. Geithner wants the financial sector to be able to take more risk – but to what end, from the point of view of society as a whole?”
Trading principles versus principal trading: the Hegelian synthesis seems far in the future.