We’ve argued that the “Volcker Rule,” which would limit “proprietary trading” by banks, is in theory a very good idea, but the proposal put forward by Volcker/Team Obama goes wide of the mark by defining any customer trade as not being part of proprietary trading. That’s a spurious distinction; large-scale position-taking well beyond what was needed for market-making dates back to the 1980s, long before firms had separate proprietary trading desks or in-house hedge funds. As a result, they looked likely to have little impact. As we noted:
You can drive a supertanker though the loopholes in this proposal, which are:
1. If a firm does not own a bank, it can do proprietary trading
2. Trades with customers are not proprietary trades
These are so silly that I’m astonished anyone is treating this proposal seriously.
Let’s dispatch them in order.
Whoever thinks that proprietary trading is just swell as long as the firm does not own a bank (meaning the kind that takes deposits) must have slept through the entire credit crisis (note I am not saying prop trading cause the crisis, but I guarantee there will still be readers who demonstrate in comments that reading comprehension is not one of their strong suits).
The implicit idea is that government backstops extend just to deposit-taking firms. That is patently ridiculous and is an attempt to hide from the public the reality of how the financial system works.
Thanks to thirty years of deregulation, a very large portion of credit intermediation (finance speak for the process of providing loans) has shifted from banks to the capital markets. As most readers know, many types of loans are originated by a bank, combined with other loans, turned into bonds, and sold to investors.
For reasons too long to go into now, bonds are traded over the counter (this is not a nefarious plot; there are legitimate reasons why). Over the counter markets have economies of scale, and in particular, network effects. So trading of credit market instruments, over, time, is dominated by a comparatively small number of very large firms.
Credit is critical to the functioning of any economy beyond the barter stage….. we have a world in which the credit markets are crucial to modern commerce, more so than banks…So any capital markets player of reasonable heft WILL be backstopped. That was the big lesson of the crisis just past and is not lost on the industry incumbents. Does anyone with an operating brain cell believe that if BofA divested Merrill and Merrill hit the wall again that it would be allowed to collapse? Look, we have twice had rescues of major non-banks, first LTCM, then AIG, due to the impact their failures would have ON CAPITAL MARKETS, not on depositors!
Clusterstock also noted:
But sources at three banks tell us that they are already finding ways to own, investment in and sponsor hedge funds and private equity funds. Even prop trading seems safe.
A person familiar with the operations of one big Wall Street bank said it expects that new regulation will affect less than 1% of its overall business.
But we also anticipated that even these weak measures would be gutted:
This is going to be very difficult to implement at this juncture, unless Team Obama has a purely regulatory solution. This should have been implemented months ago, when the banks were on the ropes and beholden to Washington. They are now emboldened and will fight tooth and nail. And the report at the Financial Times says the plan will require new legislation. Given how derivatives reform was gutted and health care reform was botched, what do you think the odds are that something with teeth will be voted in? Pretty close to zero.
And that is precisely what is happening. From the Financial Times (hat tip reader LeeAnn):
A proposal by former Federal Reserve Chairman Paul Volcker to limit bank’s proprietary trading will be either be dropped or significantly modified in the Senate…
Senate Banking Committee ranking member Richard Shelby (R-AL) said he opposes the so-called Volcker rule and the Obama administration’s call to levy a USD 90bn tax on banks. His comments come as House Financial Services Committee Chairman Barney Frank (D-MA) predicted the proposals outlined by President Obama could be law within six months.
…..Shelby said if Democrats push forward with the proposals they risk unravelling much of the bipartisan support already reached regarding the passage of financial regulatory reform in the Senate. Shelby said that the Obama administration risks losing Republican support for the bill if they begin to “politicise” the issue.
Now consider the broader implications: the Republicans don’t simply in theory have the votes to be intransigent; they have another vital element of the equation, party discipline. As James Fallows explains:
Bipartisanship in the American sense means compromising on legislation so that a sufficient number of members of Congress from BOTH parties will support it, even if (as is typically the case) a few majority party members defect and most minority party members don’t join. Bipartisanship consists of getting ENOUGH members of the minority party to join the (incomplete) majority in voting for major legislation. It can’t happen if the minority party members vote as a block against major legislation. And that can happen only if the minority party has the ability to discipline its ranks so that none join the majority, which is the unprecedented situation we’ve got in Congress today. (boldface theirs)
So take this situation to its logical conclusion. Obama can’t get anything done unless he accedes to the demands of the Republicans. And absent some sort of miracle between now and November, the Democrats look certain to lose Congressional seats in the mid-term elections. Is Obama already a lame duck? Now that may be going a tad far; after all, with nearly three more years in office, no one would question Obama’s authority to take action within normal Executive branch authority. But given Obama’s peculiar propensity to be seen as doing a lot, even when his “change” does not add up to progress, how is he going to react to the near certainty of being stymied on the domestic front? Will he seek to compensation by devoting more effort to foreign policy? Given his surprising and troubling surge strategy in Afghanistan, I’m not sure I like the possibility that Obama will try to score policy victories, and perhaps literal victories, abroad.