What’s bad for JP Morgan isn’t bad for America

By Felix Salmon
February 14, 2012
glance at the Occupy the SEC letter about the Volcker Rule before attempting to digest Andrew Ross Sorkin's column on the same subject today.

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I’d recommend that you at least glance at the Occupy the SEC letter about the Volcker Rule before attempting to digest Andrew Ross Sorkin’s column on the same subject today:

The Volcker Rule is a noble and thoughtful effort to make the banking system safer in the long-term postfinancial crisis. Critics in the banking industry, however, say the new regulation comes with many embedded costs for the national and global economy.

Here’s where Mr. Volcker and I differ. He says: “Not so.” I say: “C’mon. It’ll cost the economy, at least in the short term.”

I’m with Volcker here. And the fallacy in Sorkin’s thinking is easy to see: he’s essentially eliding big banks, on the one hand, with the broad economy, on the other. Yes, Sorkin is right that the Volcker Rule comes with “significant costs”. But there’s a difference between costs to a handful of banks, and costs to the economy.

If and when prop trading leaves the big banks, those banks will make less money. That’s by design. But the money doesn’t just disappear. Insofar as trading is a zero-sum game, and it certainly has that component, lower profits at the big banks mean higher profits everywhere else. And insofar as trading takes place outside regulated banks, at hedge funds or small broker-dealers without access to the Fed discount window, some of the profits will simply move there, to small-enough-to-fail institutions.

In other words, there is a list of institutions which will be harmed by the Volcker Rule. Here it is: JP Morgan Chase, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley. These institutions should get smaller. These institutions should be less profitable. There’s no reason to believe that when that happens, the economy as a whole will suffer.

There’s also the question of whether the Volcker Rule will hurt liquidity, and whether that would be entirely a bad thing. Sorkin happily parrots the rather ridiculous Sifma number saying that the costs of the rule could reach $350 billion. “Even half that number has to be considered substantial”, he writes, as though the best way of making a ridiculous number accurate is to simply divide it by two.

Sorkin quotes Volcker on the baseless “presumption that ever more market liquidity brings a public benefit”, but he shares that exact presumption, for no good reason. Where, exactly, is the public benefit in me being able to buy and sell stocks hundreds of times per second? Where is the benefit in bringing down trading costs to the point at which people stop thinking before they act? Liquidity is like a safety net: it allows people to feel free to make potentially stupid decisions, because they know they can always change their mind and reverse those decisions at any point. Until, of course, there’s a crisis, and correlations spike, and the safety net, just when you need it, isn’t there.

Sorkin worries that it will become “impossible, or at least, impossibly expensive” for banks to warehouse merchandise in the form of securities available for sale. He doesn’t, on the other hand, explain why that’s a bad thing. Why should commercial banks be America’s largest market-makers, with enough clout within Sifma and other industry forums that they can set the broad anti-Volcker agenda? There’s no good ex ante reason why that should be the case, and indeed commercial banks have only truly dominated the market-making world in the past few years, since Goldman Sachs and Morgan Stanley converted after Lehman went bust in 2008.

If you dig deeper into the complex needs of global corporations that are the clients of big banks these days,” writes Sorkin, doing his best Jamie Dimon impersonation, “they sometimes seek banks to make proprietary bets to help them.” Unpacking the pronouns here, I think that what Sorkin is saying is that somehow big corporations want banks to make proprietary bets, because banks’ proprietary bets somehow help those big corporations. I don’t see it — and neither does Volcker.

Yes, the Volcker Rule would hurt America’s biggest banks — and yes, those banks do have extremely large corporations as clients. Once the Volcker Rule is implemented, those extremely large corporations might find their Treasury needs best served by smaller brokerages. They might even see more competition for their dealflow, once the bigfooted giants are forced out of the game. There’s no reason to believe that the extra competition would also mean higher prices or wider spreads. So let’s concentrate on making the Volcker Rule as tough as possible, and stop worrying about its effect on Jamie Dimon’s annual bonus.


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Amen ..

Posted by Woltmann | Report as abusive

A foolish consistency is a hobgoblin to avoid, Felix. It is normal to think that something you like has only benefits and no costs. But that is only because it is comfortable, not because it is true. Life is seldom like that.

Think of what you yourself observed: the major market makers were latterly not regulated banks at all. Yet they easily converted themselves when they needed to. The reason it was easy was that they were already banks in all but name.

The modern broker-dealer requires much more capital than his small counterpart in the halcyon days you pine for. That is because much of his broking and dealing is tied to lending of one sort or another, often in disguise.

Now, you could argue that this disguised lending is an evil in itself, and that the greater public good would be served if it were brought into the open and put on an equal regulatory footing with ordinary bank lending. But that is not the argument you have made.

I think I see why you failed to make it. Had you done so, you would have been obliged to admit that these broker-dealers are indeed providing a service that is valued by their corporate clients; there could not be a market for these disguised loans otherwise. And that would have destroyed the entire point of your post. Reigning in this practice is not going to be an exercise which is completely costless except to evil banks and exclusively beneficial to everyone else. I have to say that I doubt you will carry your point if you can’t even bring yourself to identify your opponents.

Posted by Greycap | Report as abusive

“Unpacking the pronouns here, I think that what Sorkin is saying is that somehow big corporations want banks to make proprietary bets, because banks’ proprietary bets somehow help those big corporations. I don’t see it — and neither does Volcker.”

It actually seems pretty easy to see why big corporations want banks to make proprietary bets – the big multinationals want someone to take the other side of their commodity, interest rate, and currency trades/hedges. Even if the bank eventually lays off some of the risk, the corporate doesn’t want to wait, but wants quick execution, which may require a bank to take a position considered “proprietary”. A corporate may also want a bespoke product not available unless a bank serves as counterparty.

A second consideration would be if corporates think that bank liquidity keeps corporate debt spreads tighter at issuance due to lower trading costs in the secondary market, so the Volcker rule will increase corporate borrowing costs.

I don’t claim to be able to quantify either impact, but they are logically north of zero. I’ll freely concede that they could be outweighed by other considerations, but I’m addressing the argument that you don’t see how bank prop trading could possibly help large corporate clients.

Posted by realist50 | Report as abusive

What is the cost to the economy to let these motherf***ers ramp right back up like nothing ever happened and crash the world once again in 5 or 10 years?

Volcker may be gone and Dimon may be retired for the next speculative boom/bust – but how much will that one cost us if we continue to allow deposit institutions to play Paul Tudor Jones?

Posted by ReformedBroker | Report as abusive

If you were able to answer the points made by Sober Look, then I would be impressed: http://soberlook.com/2012/02/regulate-it -all-ask-questions-later.html.

Posted by Greycap | Report as abusive

My theory is that not only the too big to fail banks need to go, the too big to fail corporations need to go as well.

Posted by lhathaway | Report as abusive

@realist50: your first point implies that we’ll never get to a regulatory point where common market-making and clear prop trading are distinguishable, even on a sliding scale, on average, and even with principles-based regulation. Are you sure that is true?

Your second point is an clear showing of the subsidy that taxpayers provide to big bank holding companies, and by extension, their customers. Why should corporate borrowers magically receive the benefit of tighter spreads when the corresponding risk due to that perceived liquidity is tail-risk pushed onto the government’s balance sheet? How much did tigher spreads based on fortress balance sheets save corporate issuers over the past decade, vs. how much financial system fragility has cost over the past 4 years? Are you sure the former is a lot more than the latter?

“A corporate may also want a bespoke product not available unless a bank serves as counterparty.” It’s not about banks versus non-banks, it’s about why should a taxpayer-subsidized balance sheet be involved in that private transaction? If the company wants the product at a price not available outside of a taxpayer-subsidized balance sheet, then what does that say about whether that pricing is adequate?

@Greycap: Soberlook’s points are about why market making in corporate bonds should not be prohibited.

The main point of the Volcker rule, and Felix does confusingly commingle many different points about market making and prop trading, is that prop trading should not be allowed on the same balance sheet as depository banking. That’s not what SoberLook is objecting to, although I certainly recognize a lot of the Volcker controversy is about how hard it is to distinguish between market making and taking on proprietary risk.

Does SoberLook’s corporate bond inventory increase VaR for 12 hours while the bank is trying to hedge or offload the risk? Or does VaR increase during 3 months of capital-gains seeking with no intention to hold-to-maturity?

Assume you could easily tell the difference between market-making and prop trading – does the latter belong on a taxpayer-backed balance sheet? Why? Who benefits from that arrangement, and who might not benefit from that arrangement?

Instead of assuming a priori that the current situation is perfect and defensible, why not think about how financial benefits and risks could be better aligned across market actors and society?

Posted by SteveHamlin | Report as abusive

@SteveHamlin, what Sober Look is objecting to is the actual effect of the Volcker rule, which is to damage market making in corporate bonds. One likes to think that this is an unintended consequence of the rule, but so what? It is still a real cost.

And I could go further, because it is not only corporate bonds that are the problem. Foreign governments in Canada, Japan, and the UK are deeply unhappy that market making in their bonds will be reduced, and this is exacerbated by the preferential treatment accorded treasuries. (I notice you are silent on SL’s observation that these are in fact riskier than the prohibited products.) So the rule will also damage foreign relations with some of America’s most important allies.

As for the a priori assumption that the “current situation is perfect and defensible”, that is purely a product of your own perfervid imagination – nobody else has proposed this. Instead of projecting your fantasies onto other people, why not try reading what they say instead? Which in this case was: you cannot think about how financial benefits and risks could be better aligned across market actors and society until you are willing to acknowledge costs and not only benefits.

Posted by Greycap | Report as abusive

The question is whether the American Government should act in the interest of its most wealthy and powerful individuals and organization, like a “Banana Republic”, or act in the interest of its People as a whole.

The answer that inevitably comes from those whose plate is filled by the wealthy is that “what is good for is good for America”. And, by implication, the speaker. That person does not give a fig about whether it is good for you. That is not what they are being paid to do. The very definition of “corrupt”.

Posted by txgadfly | Report as abusive

@SteveHamlin – I agree that it could be possible to distinguish market-making and prop trading with principles-based rules. The question is if that’s what the Volcker Rule does, as formulated.

As for saying that “prop trading should not be allowed on the same balance sheet as depository banking”, it’s not clear to me how a bank holding high-grade corporate bonds for extended periods, which it sounds like some want to call a “proprietary bet”, is intrinsically any more risky than making and holding loans, which everyone in the conversation agrees is part of depository banking. Making and holding a loan, after all, is a “proprietary bet” on a number of things, most prominently the financial performance of the borrower and (usually) future interest rates.

I made this point in more detail in my comments to a previous post by Felix on the Volcker Rule -

http://blogs.reuters.com/felix-salmon/20 12/02/14/occupys-amazing-volcker-rule-le tter/

Posted by realist50 | Report as abusive

realist50, not only is it possible to distinguish prop trading vs market making but banks DO make the distinction. They are typically physically in a different area, renumerated differently and measured differently.

Posted by Danny_Black | Report as abusive

I think a large part of the problem pre-cris is that debt markets were actually too efficient. With widespread use of CDS and other techniques to mitigate risk, banks lost the discipline required to underwrite credit properly. If Volcker makes the debt markets less efficient we’ll probably all benefit.

Too-big-to-fail banks also distort the free markets that most people within these banks advocate so much. Let’s say I want part of my savings invested in dividend paying income stocks but with an allocation to more risky growth asset classes. In days gone by I’d have invested in boring bank stocks and maybe given some money to a hedge fund to use its expertise in a sector such as commodities. Now what I’m expected to do is just invest in a bank for a combination of these – or conversely, bank stocks no longer offer me the option of choosing a utility-like stock as the risky business is thrown in too. The bank’s management will take my unit of equity and allocate it where it decides, but this decision process is biased due to agency issues.

The unfair subsidy that allows these banks a higher counterparty credit rating and a cheaper cost of capital and broader access to funding than a hedge fund or other asset manager distorts competition.

Let banks return to being boring utility stocks and let private capital migrate to riskier activities. If the market decides that these activities are worth supporting on their own merits then they’ll be funded, and the protagonists will continue to be well paid if they’re successful. If capital doesn’t flow to these projects and the prop traders have nowhere to go, then they’ll have to do something else.

I’m not saying that markets are always right, and they’re certainly not always efficient, but I’d prefer capital allocation to be made on this basis rather than by banks’ management who are motivated by short-term incentives and who are not necessarily aligned with shareholders’ interests.

Posted by Stuttgart88 | Report as abusive