A closer look at the Volcker rule

January 22, 2010

There are two big questions overhanging the Volcker/Obama announcement yesterday: will it be enacted, and if it is, will it make any difference.

If you look at Obama’s rhetoric during the announcement (“if these folks want a fight, it’s a fight I’m ready to have”), the enemy is Big Finance — and certainly the Republicans would not look good if they attempted to filibuster a bill like this. The real problem, however, is the Democrats, who are surely more desperate for financial-industry money than ever, given yesterday’s Supreme Court ruling, and who have in recent years raised much more money from Wall Street than Republicans have.

Mark Thoma is as pessimistic as I’ve seen him Economics of Contempt is pessimistic when it comes to the chances that the Democrats will line up behind Obama on this one:

I don’t even know why I took the time to write about this, because there’s zero chance the proposals Obama announced today will ever be law. This was a fairly transparent political stunt — the White House needed to do something to take the media’s focus off of health care 24/7, so they flew in Volcker and announced some proposals that sound good to the media. The two Senate staffers I talk to regularly both said their offices were basically ignoring Obama’s proposals, because even if the White House fights for them (which they won’t), Chris Dodd has no intention of inserting them into his committee’s bill.

The question here is how much damage Dodd and Frank and Congressional Democrats in general will suffer if, after lining up next to Volcker and Obama yesterday, they essentially ignore the whole thing. Can failure to insert a Volcker rule into financial-reform legislation harm them politically? It’s not easy to see how it would. So I suspect that all eyes should be on Dodd and Frank for the time being: unless and until they start being as friendly with Volcker as Obama has suddenly become, there’s a good chance that this legislation will never happen. Given Dodd’s attitude to the Consumer Finance Protection Agency, I’m not holding my breath. And if you think that yesterday’s fall in the stock-market is some kind of indication that the legislation will happen, Barry Ritholtz has something to say to you.

Still, let’s say something like this passes. Will it be effective? On this front I’m cautiously optimistic. No, it won’t singlehandedly prevent another financial crisis — but I’m getting a bit tired, at this point, of people criticizing necessary moves on the grounds that they’re not sufficient. It’s true that excessive proprietary risk-taking at banks was not the proximate cause of the crisis, but that doesn’t mean we shouldn’t scale such activity back.

It’s important to appreciate, here, the pecking order within investment banks: traders rule, these days — they make orders of magnitude more money than bankers — and if you’re a trader, the more risk you take, the more money you make.

Traders start off small, filling client orders. As they become more experienced and more successful, they’re allowed to manage increasingly-large positions. You don’t need to be a prop trader to do that. Let’s say you’re trading equities, and you want to make a bet that A will rise while B won’t. Then every time a client sells you a block of A stock, you take your sweet time selling it on into the market, while your bid on B stock is less aggressive, and you will sell it with more alacrity. You’re still a client-focused market-maker, but you’re taking on extra proprietary risk.

Eventually, your risk book and your compensation becomes so big that you move over to the prop desk, where you don’t need to worry about dealing with individual clients any more — you’re just in the market, making short-term directional bets.

If you become very good at that, you’re going to start looking at the amount of money that you’re making for your employer, and thinking that you could capture a much larger chunk of that sum if you were running your own hedge fund. You then either strike out on your own, or else you threaten to strike out on your own, and stay only if your employer upgrades you from prop-desk to fully-fledged internal hedge fund.

For some reason, the vast majority of external and internal hedge funds which are started by former star traders don’t do very well: look at Goldman’s Global Alpha, or UBS’s Dillon Read Capital Management, or even for that matter Old Lane Capital Partners, an external hedge fund founded by Morgan Stanley refugees which then became an internal hedge fund at Citigroup. (Or, for that matter, just look at the internal Bear Stearns hedge funds whose collapse marked the beginning of the financial crisis.) But in any case, there’s no doubt that such funds add to the overall riskiness of their parent bank.

It’s true, then, that if you ban internal prop desks, a lot of those prop trades and traders will simply remain on the trading floor proper, where they’re nominally acting on behalf of clients — much of that risk will remain within the organization. But at the same time, if the Volcker rule passes, traders at investment banks will no longer be able to aspire to a career path where they first become prop traders and then eventually leave to start their own hedge fund, either internally or externally.

What’s more, as John Kemp has pointed out, the very fact that prop trading is banned would force regulators to be much more in market-markers’ faces than they have been until now. Thoma says that we’d be better off just boosting the budget of the regulatory agencies, but the fact is that the Volcker rule would probably have that effect. Here’s Kemp:

Enforcing a separation between proprietary trading and market making will require considerable intrusion from regulators (either in the form of rather blunt prohibitions or very intensive supervisory visits and demands for data).

Until now, supervisors have been reluctant to interfere this much in the internal workings of banks. But beefed up regulation is the inevitable condition for taxpayer support, and Obama’s endorsement will stiffen regulators’ resolve in the United States and elsewhere.

Or, to put it another way, the Volcker rule is a means to the end of increased regulatory oversight of broker-dealers. I sincerely hope it becomes a reality; we’ll see how much pressure is brought to bear on Frank and Dodd to make it so.

Update: Sorry, I thought I was quoting Mark Thoma when in fact I was quoting Economics of Contempt. It’s hard to tell when <ol> lists are blockquoted!


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