The draft Volcker Rule proposal memo that American Banker got its hands on and published today is a pretty impressive piece of work. As a reminder, people thought that a reason 2008 was so unpleasant was that banks engaged in too much risky proprietary trading. So the testudinal gentleman to the right suggested, and Congress passed, a rule to rein in risk by banning FDIC-insured banks from proprietary trading.
But that’s hard to do, since the basic securities functions of a bank – making markets for customers, and hedging risks in its market-making book or in its regular old deposits-and-loans banking activities – require trading for its own account. So the agencies implementing the rule came up with a rule proposal that sets out, in 200 pages with lots of Q&A in case you have better ideas, to figure out how to distinguish bad “proprietary trading” from good “permitted trading.”
On a first read, er, skim, it’s really smart. It looks at a bunch of different metrics to distinguish market making from prop trading, like:
- Are you actually making two-sided markets, seeing two-sided flow, etc.?
- Are you accumulating more inventory than you could possibly find a use for?
- Are you making more money from commissions/fees/spreads or from inventory appreciation?
- Are you paying people based on commissions/fees/spreads or on inventory appreciation?
- Other stuff. Really, just so much other stuff.
Here’s my favorite part, from pages 106-107 if you’re following along at home. To set the scene, the rule bans “proprietary trading,” which is defined as short-term trading by a bank as principal. But that ban does not apply to “permitted trading activities,” which include market-making and hedging. *But*, certain kinds of “permitted trading activities” go back to being not permitted, including trading activities that raise “material conflicts of interest” (“you sold me a security that was designed to fail!”) or that expose the bank to “a high-risk asset or a high-risk trading strategy.” Got that? Okay, now:
Section __.8(c) of the proposed rule defines “high-risk asset” and “high-risk trading strategy” for proposes of § __.8’s proposed limitations on permitted trading activities. Section __.8(c)(1) defines a “high-risk asset” as an asset or group of assets that would, if held by the banking entity, significantly increase the likelihood that the banking entity would incur a substantial financial loss or would fail. Section __.8(c)(2) defines a “high-risk trading strategy” as a trading strategy that would, if engaged in by the banking entity, significantly increase the likelihood that the banking entity would incur a substantial financial loss or would fail.
A footnote says that banks should have a way to figure out what is a high-risk activity, and waves at “significant embedded leverage” as maybe an indicator.
Well okay. The thought process is:
- Prop trading is risky
- Let’s ban prop trading
- Here, in 200 pages of overlapping qualitative and quantitative factors, is a comprehensive definition of prop trading
- But we may have missed something that causes risk
- So let’s also ban anything else that is risky
- And you figure out if it’s risky or not
That’s cheating! You had 200 pages to define everything that you thought was risky, why do you need to include this extra “don’t do anything else risky either” rule? Or, put another way: if you’re going to have a rule saying “don’t do anything risky,” why do you need the other 200 pages?
It would be nice to think that regulators can figure out how to keep banks from losing money, write it all down – even if it takes 200 pages – and leave it to banks to carry out. Of course, it would be surprising if that were the case: if anyone has the incentives and expertise to keep banks from losing money, it would be banks – and so far their performance has been so-so. The mammoth draft Volcker Rule is an impressive effort to understand and specify the distinction, hard to draw precisely, between proprietary and market-making-and-hedging activities. But if you want to know whether all this careful definitional work will prevent another bank meltdown or financial crisis, the fact that the regulators felt the need to add “and don’t do anything else risky either” at the end is not all that hopeful a sign.