Here’s Charles Dumas of Lombard Street Research with an aggressively “pro” take on the Volcker rule…
Obama-Volcker on target, avoid Glass-Steagall
The furore over bankers’ bonuses illustrates one aspect of current financial market conduct that has wide implications: the casual slippage back to “normalcy”, interpreted as business-as-usual 2007-style. It seems clear to us that normalcy is a long way off (if it has ever existed). Indeed, complacency in many quarters about economic recovery, and the illusion of normalcy, is itself a reason why renewed economic and financial trouble, probably crisis, is likely. The drop in bank shares yesterday on the announcement of new regulatory plans by Mr Obama, originated by former Fed governor Volcker, is a classic case of blinkers falling from the eyes of financial markets that have been amazingly credulous of delusions in recent years (if not always). One thinks of the Latino debt farrago (“countries can’t go bankrupt”), the high-leverage, saving-andloans bubble, the tech bubble, as much as the recent alphabet-soup mortgage bubble. These were obvious cases where a little scepticism, and willingness to look at situations from multiple perspectives, seemed to be beyond the reach of market participants, or their educators.
The new plan is well conceived to reduce banking conflicts that the market has shown itself unable to self-regulate, and indirectly to create natural curbs on excessive remuneration. At the same time it avoids the widely touted return to Glass-Steagall, which would be highly destructive in view of financial market innovations, especially since the 1980s but arguably the entire period since the flotation of the dollar in 1971. To be effective, the proposals should also require continued, relatively intrusive regulatory oversight, and that is all to the good.
There is an obvious conflict between banks holding own-account positions in key markets where they are also the leading market-makers making prices for clients. It is not just a question of “front-running”, where a dealer positions his own account first, and then moves the price in his favour by putting through a large client transaction. More dangerous are the situations amusingly detailed in Michael Lewis’s “Liar’s Poker” where a bank wishing to shed a position sets its sales force to work to stuff them into a client’s book by outright lying. Even without such foul play, a market-making bank that deals with major client flows, even, for example, with central banks, has a major advantage over other investors, and should not be able to trade profitably off that. Policing the distinction between own-account trading and legitimate hedging of positions taken as a result of market-making for a client is clearly going to be difficult and often somewhat arbitrary. It will also require close regulatory oversight – a good thing in itself, since the financial industry has for too long lived in a solipsist, self-referencing world that precludes self-discipline
Close policing may not solve some of the inevitable arbitrariness of the new distinction, but it should ensure that the development of bubble-like excesses is spotted and thwarted a little earlier than has been typical in recent years.
For banks’ shareholders, the forcing out of own-account trading into separate organisations is all to the good. Under the arrangements of recent decades, diffuse shareholders of banks have been hopelessly out-gunned by the greatest capitalists in the history of the world: their employees. Yet the profits accruing from banker activities on behalf of their firms are mostly to the credit of the firm, not the employee. Many were the employees who left my old firm, J P Morgan, to work for themselves – and almost as many were the ones who soon came back to the comfort zone of JPM. It was – and remains – largely the J P Morgan name, balance sheet, support system, and reputation that made the money, not the employee. If a person wants to make the sort of money that was wrongly being handed out at quite low levels in such banks in recent years, they should go it alone, as a hedge fund, for example. The only people that should get rewards on the recent scale are the ones who really make a difference: the top management that genuinely does create the reputation, operating culture and organisation of the firm. The new regulations, by sharply limiting the scope for traders and others within regulated banks to run books and claim undue credit for their profits, should force out the ones wishing to make huge rewards to set up their own businesses – while those that stay “in the warm” get the good but not immoderate pay they deserve. Good traders will always be taking more risk than most in a bank, and so should be comparatively well paid, but recent rewards have been excessive, and unnecessary. So it is far from clear that these proposals are bad for bank shareholders, as opposed to employees getting huge bonuses. So the stock market yesterday may have been dominated, as often, by the interests of the bankers rather than the owners of the banks.
The new proposals may be too strict on banks holding interests in hedge funds. Provided banks do so at holding-company level, outside the regulated subsidiaries that should contain the bulk of the business and capital of the firm, and with “Chinese Walls” to prevent any organisational links between the hedge fund management and the operating banking subsidiaries, it is hard to see the objection – beyond some overall limit on the relative size of such holdings. A better line to take in terms of preventing conflicts of interest might be to question the ownership by banks of asset management subsidiaries – this has led to identifiable conflicts of interest, including in high-profile mergers/acquisition deals.
Some of the commentary in the papers appeared to imply that the likes of Goldman Sachs and Morgan Stanley could escape all of this by giving up their banking charters, and reverting to investment bank status. This would be a mistake, as it would ignore the point that balance sheet size was what created the Lehman disaster, given the intricate web of derivatives that will under any future scenario link deposit-taking banks and other financial institutions inextricably together. The argument against Glass-Steagall in modern conditions is precisely that conventional banking activities (in the Glass Steagall sense) now inevitably are accompanies by associated derivative and other hedging activities that are in themselves – as naked positions – just as risky as anything that was banished from conventional commercial banking to the investment banking arena under Glass-Steagall. So that kind of risk-taking is inherent to modern banking, and has been ever since the invention of the interest-rate swap in the early 1980s (if not the emergence of floating exchange rates in the 1970s). Equally, investment bankers now have to be able to offer such swaps, and other long-lasting derivatives, that require a large, healthy balance sheet – hence the convergence of commercial and investment banking over the past 30 years.
All institutions with a balance sheet of significant size need to be regulated, if the Lehman-type scenario is to be minimised. And if servicing clients needing to deal precludes own-account trading, that principle applies as much to market-making by investment banks as deposit-taking institutions. Just as importantly, it should be a priority to insist that the new, presumably higher and safer, required levels of regulatory capital are kept within the subsidiaries that engage in the transactions the capital is supposed to support. If this incidentally stops a lot of tax-dodging by banks holding their capital in tax havens while the deals are done in major capitals, so much the better – it is the taxpayers in the major capitals that have had to bail them out.
The lack of international coordination has been lamented in some quarters. But it was always a chimera. A strong lead from a man like Volcker is so obviously vastly superior to prolonged negotiations with a bunch of muddle-headed continental Europeans, who do not understand and dislike finance in the first place, that we should all emit a sigh of relief on that point. The British will behave much more justifiably like “poodles” (a much maligned breed, by the way) on this issue than on others in recent years, and the rest can just follow along when they make up their minds to do so.
President Obama probably feels he has had a bad week. But it may prove to have been a good one for world welfare!