The top story at the Financial Times at this hour, “‘Volcker rule’ gives Goldman stark choice,” is a accurate report of Paul Volcker’s latest remarks, but gives a wildly misleading impression of the “choice” facing Goldman:
Goldman Sachs and other banks should give up their bank status if they want to avoid the ban on proprietary trading proposed by the White House, Paul Volcker, head of President Barack Obama’s Economic Recovery Advisory Board, said.
“The implication for Goldman Sachs or any other institution is, do you want to be a bank?” Mr Volcker said in a video interviewvideo interview with the Financial Times. “If you don’t want to follow those [banking] rules, you want to go out and do a lot of proprietary stuff, fine, but don’t do it with a banking licence.”
Yves here. Oh, so Goldman has to chose between prop trading, aka being in some high return businesses, or being a bank. But why in God’s name does Goldman want or need to be a bank?
Let’s rerun the tape on the crisis. Two investment banks, Bear and Merrill, were kept from failing subsidized mergers into banks. The conventional wisdom is that allowing Lehman to fail was a really bad idea, although a significant minority school of though holds that if there was a better organized way for Lehman to have failed, maybe that would not have been so terrible. Morgan Stanley and Goldman got cheap money, TARP equity, access to lotsa special facilities to keep them from falling over. They were given banking licenses simply to make it legally (and therefore operationally) easier for the Fed to give them access to emergency cash.
So what is the lesson? If you are a big enough player in the financial markets, you will not be permitted to fail, particularly after the blowback of the Lehman collapse. And the Fed has gotten over the intellectual and procedural hurdle of letting an investment bank become a bank holding company a when it looks desirable. So hey, just go back to being an investment bank, if you and your buddies screw up the financial system again, the Fed will find some way to rescue you. And they’ll probably be faster about it, since they just have to restart mechanisms they set up in the crisis.
Now the answer is that banks and firms like Goldman (assuming Goldman decided to give up its banking license) is that these systemically important firms will have had to come up with living wills, they will be wound down if they become insolvent.
I’m pretty skeptical of this idea. Goldman and other players active in the debt and OTC derivatives markets have extensive counterparty exposures. Moreover, if one firm was on the brink of failure, it is likely that others are vulnerable too, that the turn of events that led one firm to be in serious trouble has affected others as well.
So you have two risks: that the mechanics of winding down the euthanized firm will be seen as interfering with, and potentially damaging, the operations of its counterparties (how can you hold creditors at bay without freezing positions? How can you let an insolvent company continue to trade? I don’t see clean answers to this problem). Independent of the operational problem of an untested process for winding down a trading firm (which is likely to make counterparties and customers nervous) you have the separate risk of contagion, the fact that one firm has been taken down can lead to a run on others.
Unless I see a great deal more done to solve the problem of connectedness, and I see perilous little here (we’ve discussed the considerable shortcomings of derivatives “reform” in previous posts, and even that inadequate plan may not be passed), one major financial firm going down will still have the potential to jeopardize others.
Let’s use a simple metaphor. Say a real moron designed a bunch of nuclear reactors. Not only do they have the risk of suffering an uncontrolled chain reaction every ten years (aka a meltdown) but when one reactor goes haywire, it has high odds of triggering similar behavior in other reactors.
You have a costly and politically unpopular way of controlling a reactor that looks in danger of going critical but it leaves the faulty reactor in operation. You have a cheaper and untested way that that your engineers devised that might allow you to shut down the reactor if it misbehaves again. But if it doesn’t work, the other reactors will go critical.
Now in a real world situation, what do you think the government will do? Even if the engineers’ plan sounds great, is anybody going to risk a test on an untried approach with so much at stake? The banking industry (remember, it is full of narcissists) is likely to assume not and act as if they have a backstop. Recall that is the biggest danger here, not so much what the government actually does in the next crisis, but what the incumbents believe it will do, since that will affect how much risk they take.
But in a replay of Lehman, the powers that be may feel compelled to take a stand and shut down a troubled firm. And if it goes badly, we’ll be right back to a “no more Lehman/____” policy for the rest of the crisis.
And the amazing confirmation of sorts comes at end of the article:
Goldman declined to comment but executives say that if the Volcker Rule is passed, it would probably sell its deposit-taking bank, which is an insignificant part of Goldman’s $900bn-plus balance sheet.
However, Goldman leaders do not believe they would have to give up the financial holding company status acquired at the height of the 2008 crisis to escape the rule’s ban on in-house trading.
Yves here. So get this: Goldman believes that to escape the Volcker rule, all it has to do is ditch its depositary. It can still keep its bank holding company license, which was granted to make it easier for the Fed to lend to Goldman. It also appears that Goldman will keep its FDIC guaranteed deb outstanding too.
In other words, Goldman will be able to keep the most important bennies of its status of being a bank, that of ready access to a Fed lifeline, as long as it makes an “appease the peasants” disposition of its depositary, in the hope that no one gets what is really going on.
A former Fed staffer wrote me early after the Obama administration started making Volcker the front man for its new banking reform PR campaign, saying “I can’t believe Volcker is allowing himself to be used like this.” I cant’ fathom it either, but it certainly looks like that is what is happening.