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| Satyajit Das: Paul Volcker's Trojan Horse | | Controlling proprietary trading may be a Trojan horse for redefining the banking reform agenda |
| Satyajit Das / Feb 26, 2010, 00:12 IST |
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Some financial regulation proposals are not quite what they seem. Named after Paul Volcker, the six-foot-seven-inch former Chairman of the Federal Reserve, the eponymous rule restricts banks from proprietary trading and investing in hedge or private equity funds. The primary aim is to prevent depositor funds from being risked in speculative investments and activities.
Popular narrative on the proposal has focused on the practical problems of the proposal. But as Albert Einstein knew: “If at first, the idea is not absurd, then there is no hope for it.”
Distinguishing between proprietary trading and agency business (matching clients) is not easy. A trader may buy a security with the intention of selling it to another client. The trader risks his or her own capital in holding the position until an offsetting counterparty is available. It is not clear whether this constitutes “proprietary trading”. Policing trading activities may literally require a regulator on the shoulder of every trader.
Paul Volcker’s testimony to Congress highlighted the problem, when he indicated elliptically that every banker knew whether he or she was trading on proprietary account. It was reminiscent of US Supreme Court Justice Potter Stewart’s famous statement that while he found it hard to define, he knew pornography when he saw it.
The Volcker Rule does not also cover other arguably more significant risks — such as credit risk of loss on loans or liquidity risks — which have been a major problem in the current crisis.
The narrative misses the point that controlling proprietary trading may be a “Trojan Horse” for subtly redefining the existing banking reform agenda.
A key agenda item is the reduction in the role of financial services in the broader economy. The US financial services industry’s share of total corporate profits increased to around 40 per cent in 2007 from 10 per cent in the early 1980s. Similarly, the value of the US financial services industry increased to 23 per cent of the total stock market value in 2007 from 6 per cent in the early 1980s.
Interestingly, banks suggest that trading profits are low (less than 10 per cent). This relies on the same semantic games defining “proprietary trading”. If trading earnings are so insignificant, then why are banks resisting the proposal?
Reduction in trading would reduce the size of banks, their profits and their impact on the wider economy.
The Volcker Rule covertly introduces the concept of “narrow banking”. If banks are not allowed to trade directly or indirectly via investment vehicles, then what remains is the core “utility function” — taking deposits and making loans or providing advice. This would de facto achieve the same separation of traditional and “casino banking” as the now-repealed Glass-Steagall Act did.
The Volcker Rule and the focus on banker remuneration may encourage investment banks that converted to commercial banks to reverse their status. It may encourage them to go private, forcing a return to quasi partnerships. This would force partners to risk their own money in trading and also constrain the capital available to support trading. The conversion of investment banks from private partnerships to public companies and the resultant increased access to capital — other people’s money — coincided with increases in risk-taking.
Volcker has been openly sceptical about the contribution of financial innovation to economic activity. The proposal marks a notable reversal in the emphasis on trading in financial instruments to facilitate capital formation and lower costs of capital. It also marks a shift away from market and trading-oriented economic solutions.
Analysts have focused on the impact of financial regulation on bank earnings and prospects. If the broad principles underlying the Volcker Rule — reducing risky activities within banks — is accepted, then the resultant changes in the broader economy and markets will be significant. It may be back to the future for banking and the economy.
With legislators and regulators considering changes to the financial markets, the debate regarding the Volcker Rule is particularly relevant to India. While there is a need to deregulate, it is essential that care is taken to ensure that the type of “financialisation” of the economy that took place in the US and Great Britain is avoided.
Finance always should be a handmaiden to the broader economy, not the entire economy itself. It should facilitate capital formation and risk management. Finance cannot replace (the) real industry, nor is speculation a substitute for (a) sound industry. As John Maynard Keynes warned: “Speculators may do no harm as the bubble on a steady stream of enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill done.”
James Baker once stated: “Never let the other fellow set the agenda.” Whatever the merits of the narrow Volcker Rule, the former Fed chairman is taking advantage of the crisis to cunningly reshape the financial reform agenda.
Satyajit Das is the author of recently released
Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives; Revised Edition (2010, FT-Prentice Hall)
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