As readers know, this blog has LOOONG been a critic of the Treasury Department’s stance towards big dealer banks, both in the Paulson era and from the very get-go of Geithner’s tenure. So on those all-too-rare occasions when Treasury seems willing to meddle in a real way with the “heads we win, tails you lose” arrangement the financial services industry has managed to devise with broader society, it’s important to applaud those efforts.
Admittedly, it is premature to declare victory, but the fact that Treasury is even taking a serious stance on the so-called Volcker rule is a surprise. Conventional wisdom on financial reform, and it is being borne out in the backroom wheeling and dealing on derivatives regulation, is that despite the length of the Dodd-Frank bill, numerous key details remained to be worked out in detailed provisions which were to be negotiated with industry incumbents. That looked to be a way to retrade the deal, since the legislation could be interpreted as narrowly as possible, with the end result that the industry incumbents would be merely inconvenienced, as opposed to required to do business in fundamentally different ways.
We had doubted from the outset that one widely-touted reform plank, the so-called Volcker rule, would amount to much. Not that we disagreed with the high concept; indeed, the general precept is correct. Major financial firms have government support because they provide essential social services. The various forms of support should not be used to subsidize activities that do not have broad social benefits and/or are profitable enough so as not to require subsidies for private actors to fulfill those functions. The Volcker rule thus sought to restrict banks from speculating with house funds for the purpose of padding their own bottom lines, so called proprietary trading.
That sounded all well and good. But what, pray tell, was a proprietary trade? It ought to encompass any in-house investment, such as hedge funds and private equity funds (sadly, those are still permitted, although the banks are restricted as to how much capital they can commit to them). But the big question lay with what to do with so-called proprietary trading desks, traders that played with the house’s money, typically in dedicated business units that were not obligated to trade directly with pesky customers.
But the Volcker rule, at least as presented by Volcker himself, drew a spurious distinction: any trade with a customer was to be considered a non-proprietary trade. That was misguided. Prop traders don’t make markets with customers, but the vast majority of their trades are with end-users, not with professional dealers at other firms (the prop desk will often hand an order off to be worked on another desk).
However, as reported by the Financial Times, Treasury appears to have embraced what Volcker intended at the outset, as opposed to his non-trader-savvy further formulation. One encouraging element is that they appear to be looking at multiple considerations in judging what is a prop trade; single rules are much easier to game.
From the Financial Times:
US regulators are pressing for strict definitions of proprietary trading activities to be banned under the Dodd-Frank financial reform law in a move that could anger bankers and some of their toughest critics…
But the US Treasury, which chairs the regulatory panel drawing up detailed rules, wants to base the definition of proprietary trading on measurable metrics to prevent banks from getting around the law.
Wall Street executives said government officials indicated they were interested in looking at the length of time a bank holds a trading position, its size and risk, when deciding whether a transaction constitutes proprietary trading or market-making on behalf of customers.
Now this is admittedly Treasury’s opening position; given how the Obama administration has repeatedly engaged in bold talk and then caved to vested interests, it’s premature to conclude that we will see a taxpayer-favorable outcome here. But this is a tougher stance than I had envisioned they would take.
Of course, there are simpler approaches, namely keep the rules a bit mysterious but make the consequences of violating it draconian. Economics of Contempt supplies an elegant solution:
The proposal: If a trader is found by regulators to have violated the Volcker rule more than once in a calendar year, his pay cannot be more than $100K for that year. No exceptions. No million dollar bonuses. If the trader has already received more than $100K in base salary for the year, then he has to pay back any amount over $100K. Believe me, once a trader has violated the Volcker rule once, he’ll be falling all over himself to document why and how every trade is related to market-making.