Thursday, January 28, 2010

Limits On Bank Risk Taking Could Be Good For Everyone

While the explanation by Obama on plans to introduce the "Volcker Rule" may have been poorly communicated, the limitations to bank risk taking could improve the financial system in the end. Eric Jackson from The Street discusses why the negatives of lower bank profits, lower liquidity would be greatly outweighed by the reduced risk for the US financial system. See the following article from The Street for more on this.

The proposed "Volcker Rule" isn't about being anti-business, it's about letting market actors do what they're best at.

Let banks bank, and let hedge funds trade. When either one does a poor job, let it go under and not pull the rest of the system with it. That's capitalism.

If bankers want to throw their own profits down a rat-hole with poor risk management, that's their right. Just don't do it with depositors' money

Last week, President Obama announced a series of planned reforms for the financial industry to prevent "too-big-to-fail" bank failures.

The centerpiece of these reforms was the so-called Volcker Rule, which restricts banks from getting into proprietary trading and owning, investing or sponsoring hedge funds or private-equity funds.

There has been much concern and hand-wringing about the long-term impact of these proposed changes since the announcement. The market -- and especially large bank stocks -- took a major hit following the announcement. The fears expressed were that Obama is anti-business and his misguided policies were going to kill off a nascent recovery just as it is starting to gain strength.

Hang on. First, we blame Obama that he, Treasury Secretary Tim Geithner, and Fed Chairman Ben Bernanke are too cozy with Wall Street, and no rules have been changed since the economic crisis began. Now, he's anti-business and his moves to reform the system to prevent systemwide risks are going too far.

Obama, generally regarded as a master communicator, did a horrendous job announcing the Volcker Rule. He came out, made an eight-minute speech, had no documentation to back it up and left after taking no questions.

Worse, his language was imprecise. The vacuum of information has directly led to the gnashing of teeth we've heard since then. Even now, a week later, we don't have further clarification. It's allowed pundits to surmise that the announcement was a knee-jerk reaction to last Tuesday's Massachusetts Senate loss. According to them, he's trying to be the left's populist version of Glenn Beck.

What was also confusing was that, after saying that banks couldn't do proprietary trading or even invest in a hedge fund or private equity fund, he said the following:

"If financial firms want to trade for profit, that's something they're free to do. Indeed, doing so responsibly is a good thing for the markets and the economy. But these firms should not be allowed to run these hedge funds and private equities -- funds while running a bank backed by the American people."

I think we're all speculating -- he meant to say it was fine for banks to take some of their own money (as opposed to depositors' money) and trade it. What is not OK is taking in depositors' capital, that which is federally protected by the Federal Deposit Insurance Corp. and then levering it up 40-1 and making big bets.

As I argued in an article last month, why is it that hedge funds have to trade their own money or go out and justify to skeptical outside investors why their strategies and risk management are worthy of receiving capital -- and yet banks get to take in deposits from mom and pop and then trade them without having to justify anything?

I believe that it was big bankers' desire to keep their talent, maximize their profits and maximize their take-home pay that encouraged them to make bigger and riskier trading bets as last decade rolled on.

Those with the best risk management -- like Goldman Sachs(GS Quote) -- did well. Those with the poorest risk management - like Citigroup(C Quote) -- did the worst and have cost U.S. taxpayers the most.

The Volcker Rule is saying that banks can trade their own profits if they want but it should be their money -- not depositors' -- and stupid losses shouldn't bring down the whole enterprise and infect the system.

The arguments against the Volcker Rule are that: (1) it's not defined, (2) proprietary trading represents "only 10%" of banks' profits, and (3) doing this will reduce liquidity in the marketplace. In other words, the bankers are saying, "We're doing God's work, by buying positions from clients and putting them on our balance sheets -- and what will these poor souls do without us?"

First, it is not well-defined. This brief and vague announcement reminds me of Geithner's first public comments after being sworn in as Treasury secretary in February 2009. He said he was going to do something, but he didn't say what, and he had no staff to do anything anyway. The markets tanked for another month on fears he had no control of the situation. Finally, he released a more detailed policy paper and the criticisms of him slowed down.

On the point of this only being a small part of the banks' profits, well, then, they should have no problem giving this up. The truth is that these banks rely on these profits. Why would they want to give them up if they didn't have to? The question is: Does taking their right to trade depositors' money make the system stronger? I think the answer is clearly yes. (And, a note to Goldman Sachs: if you don't like these rules, don't classify yourself as a bank holding company, allowing you to borrow money from the Federal Reserve for free.)

As for reduced liquidity, just as when you divert a river, you can't stop the flow of a current. Capital will find a place to trade what it needs to. Hedge funds will likely step up to fill any hole left over from the banks.

What are the long-term impacts here of this rule, if it is enacted? Bank profitability will go down. Talent and assets will flow to hedge funds, away from big banks. Liquidity will find a home and be served. And the systemwide risk of big banks will be lowered, which most would agree is a good thing after 2008.

You can't make an omelet without breaking some eggs. And you can't reform Wall Street without actually putting some reforms in place. This rule will be a good thing for all market participants in the long run.

This post has been republished from
The Street.

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