THE BEAR'S LAIR Let's atomize Wall Street
By Martin Hutchinson
The proposal by former Federal Reserve chairman Paul Volcker that proprietary
trading should be spun off from deposit-taking banks is a worthwhile step in
the direction of stabilizing the financial services business. However, when you
consider that business in detail, it becomes clear that further breakups are
necessary in order to remove the excessive risks from the US economic system.
Volcker became something of a hero to the left for his sponsorship of President
Barack Obama's bank-bashing announcement. Indeed, I was very much hoping that
Obama could ride this new-found enthusiasm through a defeat of Ben Bernanke in
his senate confirmation vote, followed by a more or less unanimous senate
approval of a Volcker nomination to replace
him as Fed chairman. Assuming Volcker hadn't suffered a Damascene conversion to
sloppy monetary policy while I wasn't looking, Obama and the left would be
suffering buyer's remorse within about an hour of Volcker's arrival at the Fed,
but by that stage the deed would be done. I was practicing my Dr Evil laugh for
this eventuality, but alas it was not to be.
There are three problems with the current setup on Wall Street: systemic risk,
rent seeking and conflicts of interest. The Volcker proposal addresses the
systemic risk problem to a great extent, but does not do much about the other
two. For a complete solution, we thus need to go further.
When then Treasury secretary Larry Summers and former senator Phil Gramm
(R-Texas), among others, pushed through repeal of the Glass-Steagall Act in
1999, they didn't give proper thought to the dangers of institutions funding a
traders' casino with guaranteed deposits. The introduction of Glass-Steagall in
1934 had been highly damaging to the economy because it decapitalized the
investment banks, killing off the capital markets for the remainder of the
1930s and playing a major role in prolonging the Great Depression. However, by
1999, the investment banks were more than adequately capitalized (provided they
followed sound principles of risk management and leverage, which of course they
increasingly didn't). Thus, the rationale for allowing commercial banking and
investment banking to be combined was shaky at best. It should have caused
further doubt that the trigger for Glass-Steagall repeal was the acquisition of
the investment bank Salomon Brothers by Citigroup, itself a quagmire of
conflicts of interest that had been bailed out from bankruptcy only eight years
before.
However, restoring Glass-Steagall as it was would achieve nothing. After all,
the two most serious failures of risk management in the 2008 crash were
collateralized debt obligations, involving a mortgage bond market in which
commercial banks' securitization operations have always been active, and credit
default swaps, a product in which commercial banks were intimately involved
from the first.
Conventional underwriting of corporate debt and equity securities, the activity
prohibited to commercial banks by Glass-Steagall, was not the problem, as it
might have been had the crash occurred with the bursting of the 1999 dot-com
bubble. The principal risks involved in finance today are those incurred by
traders, but those proliferate in both types of banking.
It's not clear how Volcker's ban on proprietary trading in banks benefiting
from deposit insurance would work. Every bank foreign exchange desk and money
desk trades on the bank's own account in almost every transaction it makes
(relatively few transactions are pure brokerage between two counterparties.)
Thus, however simple the bank's operations, it cannot avoid "proprietary
trading". Of course you can ban separate "prop trading" desks, but, in a
naughty world, that would drive the proprietary traders to integrate themselves
into the operations of the various products concerned, thus negating the effect
of the legislation.
The other problem with the Volcker proposal is that even without separate
proprietary trading operations, the banks are undertaking risks which they
don't manage properly. Wall Street risk management systems are based on
assumptions of Gaussian randomness in markets that are demonstrably far from
realistic. In particular, Wall Street risk management systems understate the
risk of several highly risky products such as collateralized debt obligations
and credit default swaps. This understatement is in the interest of bank
management, which benefits from state bailouts when it all goes wrong. It is
even more in the interest of traders, who by and large make the most money from
trading the riskiest instruments, and hence welcome artificially large position
limits for those instruments.
Since current Wall Street risk management methods are in the interest of those
who work on Wall Street, they will not be changed except by regulatory means.
Before their alteration, they will, even without proprietary trading, leave the
Wall Street behemoths in continual danger of explosion.
Rent-seeking is another current problem of Wall Street not addressed by
Volcker. This takes many forms, and has resulted from computerization and from
the endless proliferation of derivative instruments. Basically, Wall Street
houses, by their substantial market share in trading businesses, acquire
insider information about money flows, then profit by trading on this
information. Traders have always done this, of course, and there is no sensible
way of making it illegal. In addition, genuine "crony capitalism" insider
information about future finances and future government actions is as available
as it always has been, but with larger trading volumes and fewer inhibitions it
is more usable without technically contravening insider treading legislation.
Thus insider trading, almost all of it technically legal, has acquired an
enormously magnified profit potential. This is the principal reason for Wall
Street's greater share of the economy; the genuine value added to third parties
from "hedging" or liquidity" is only a tiny fraction of the rents Wall Street
can extract from these markets.
There is no complete solution to this problem, but the best palliative is a
"Tobin tax", a modest ad valorem transaction tax on each trade. By this means,
the profitability of "high speed trading" would be eliminated and many of the
other insider trading strategies would be reduced in scope and profitability,
particularly if the tax were levied on the nominal principal amount of a
derivative and not on its theoretical value. This would in turn swing the power
base within Wall Street away from traders and back towards bankers and
corporate financiers, whose approach to life is more conducive to maximizing
those houses' genuine economic value added.
The final problem in the Wall Street behemoths, that of conflicts of interest,
requires no legislative solution, at least as far as the corporate customers
are concerned, but only that the financing business remain adequately
competitive. With behemoths doing corporate financing transactions, any of
their customers is faced with huge conflicts in dealing with them. If a company
provides them with sensitive corporate data, it may be subjected to a leveraged
buyout. If a company entrusts them with a new financing, it may find their
trading operation shorting it, either directly or indirectly. (Those mortgage
originators and investors still in business, for example, can reasonably feel
miffed with Goldman Sachs making a profit from shorting subprime mortgage bonds
through the CDS market while it was at the same time issuing and selling new
ones).
Wall Street pretends to operate internal "Chinese walls" through which
sensitive information does not penetrate, but to rely on those is to put
yourself entirely under the protection of Wall Street's ethical integrity, a
security currently trading at a very substantial discount.
The solution to these conflicts of interest is "single capacity", the system
under which the City of London acted until the passage of the Financial
Services Act of 1986, surely among the most misguided pieces of legislation in
human history. Under this system brokers, who sold securities, were kept
separate from jobbers, who made markets in them. Both were separate from
merchant bankers who arranged financings and carried out mergers and
acquisition transactions.
When an underwriting took place, the merchant bank arranged the transaction and
the brokers sold the underwriting to insurance companies and other large
investment institutions, who earned additional income by backstopping deals in
this way. "Proprietary trading" was undertaken by investment trusts, pools of
money whose business was to maximize income for their investors, in a similar
way to a US hedge fund. As for banking, that was done by the merchant banks if
complicated, but the high volume simple transactions were carried out by the
clearing banks, home of the nation's retail deposits but not known for their
intellectual heavy lifting.
It worked beautifully, just as well as the modern system, indeed better. It
cost far less, in terms of the wealth it extracted from the economy. It was
much less risky. And there were few conflicts of interest; each participant in
the business, having only one function and capability, was devoted to its own
interest rather than torn between the interests of several participants in
every transaction.
This system is to some extent returning anyway, with the increasing market
share of "boutique" investment banks such as Greenhill & Co and Evercore
Partners, which at least have fewer conflicts of interest than the behemoths.
However, a regulatory "nudge" or two would be no bad thing.
As I said, Volcker had a good idea, but he did not go nearly far enough.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-10 David W Tice & Associates.)
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