What is this S&P paper on how the Volcker Rule could force S&P to lower ratings on banks? One basic intuition you could have is that the earnings you get from prop trading are not particularly stable so shouldn’t count for much in your credit ratings; on this intuition things like highly levered hedge funds and Berkshire Hathaway should be bad unsecured credits so, y’know, shows what I know.1 But really if you had to choose purely from a credit ratings perspective between:
- Thing A makes $1 billion a year on like investment banking fees and stock trading commissions, versus
- Thing B makes $2 billion a year on prop trading some stuff, but it won’t tell you what stuff, but it’s all financed with repo,
You’d pick Thing A, right? To lend to? To some approximation the guys who’ve blown up their creditors are the guys with risk positions on their balance sheets (Lehman, MF Global); the guys who just run out of fee-based business mostly wind up their debts before expiring. Or don’t have many debts to begin with, because why would you incur massive unsecured debts to just execute client orders on commission?2 Anyway here’s S&P:
In our analysis, we consider two possible forms the final Volcker Rule may take. Under a less strict outcome, we assume the rule would permit most current trading activities so long as trading is related to serving clients’ liquidity needs and a bank can clearly prove that it’s compliant with the rules. How a bank might provide clear evidence that the trade was really only for serving clients’ needs and not for its own profit may be excessively complicated in the current version of the rule. This less strict determination would have a limited impact on banks’ revenues, profits, and business positions, as defined in our criteria.
On the other hand, we assume that a stricter final rule would prohibit many current trading activities. The rule could limit bank trading to matching buyers and sellers while avoiding taking price risk (i.e., making profits from price movements) in securities held in inventory. However, how this would operate in practice remains unclear as holding inventory allows banks to provide liquidity to the capital markets. We believe a stricter rule could significantly hurt some banks’ revenues and profits because of a substantial reduction in trading.
This strikes me as a weird characterization of the possibilities but whatever; I suspect that the thing where banks cannot be market makers or hold inventories at all (the “stricter final rule”) is unlikely though I suppose the “nothing at all changes” outcome is also pretty unlikely. But even in the no-market-maker world, places like Goldman and Morgan Stanley – the banks at whom S&P is most emphatically rattling its saber – will not obviously be worse credits, because they’ll just be, like, people in a room full of money talking on telephones, and they’ll only need to borrow money to pay for the room and the telephones. You can’t lose money on your positions if you don’t have positions; nor can you default on the debt that you’ve taken out to fund those non-positions.
Now, it is the case that some politicians think that all market making, hedging and other trading by banks should be banned. And they think that this would make the banks safer, though S&P – probably correctly? – thinks otherwise. And if you also believe – as I suspect few anti-bank politicians do, but whatever – that S&P is an important objective arbiter of bank safety, and that “bank safety” as politicians conceive it is roughly synonymous with “bank credit ratings” as S&P conceives it, then I guess this paper would give the banks ammunition to lobby against a harsher Volcker Rule. “No no no,” they’d say, “banning trading won’t make us safer, it’ll make us riskier. See, S&P says so right here.”
Float lazily on a vague cloud of suspicion to this bracing paper on credit ratings from the European Central Bank that contains the following sentences:
Our results suggest that rating agencies assign more positive ratings to large banks and to those institutions more likely to provide the rating agency with additional securities rating business (as indicated by private structured credit origination activity). These competitive distortions are economically significant and help perpetuate the existence of ‘too-big-to-fail’ banks.
If you’re being awfully cynical you might notice that a world with a very strict Volcker Rule would also likely be a world with rather less structured credit origination and then you’d connect various dots and, um, pretty much wind up with this S&P paper.
Cynicism abounds today, Greg Smith‘s influence perhaps. In other papers-whose-abstracts-I-skimmed-today news, I’m enjoying this paper by Stanford law prof Kathryn Judge on a thing called “interbank discipline,” which is basically the concept that banks should want other banks – their counterparties – not to blow up and so should take steps to accomplish that end, such as making sure that the other banks’ balance sheets are not full of lies and bombs, which is mostly good because nobody else is particularly doing that, but not entirely good because bank-counterparties’ interests do not fully coincide with everyone else’s. It’s a law paper, so it’s sort of heavy on intuition and light on empiricism, but the intuitions seem good. (Intuitively!) Here is a good intuition:
A bank’s counterparties and other creditors, for example, are likely to reward a bank for becoming too big to fail, because as their assessment of the probability that the government will intervene to save a bank goes up, so too does their willingness to work with that bank. The Crisis revealed that the social costs of a bank’s demise may similarly dwarf the losses incurred by the bank and its stakeholders when a bank is too interconnected or too correlated. This Article suggests that banks are more likely to reward such changes in a bank’s risk profile than other market participants. This occurs with respect to interconnectedness because a bank doubly benefits when it enters into a new relationship with another bank. The bank itself becomes more interconnected, increasing the probability it will be bailed out; and, the credit risk posed it assumes with respect to the other bank is reduced, at the margins, by the increased probability the other bank will be bailed out.
Basically every bank should want to do all its trading with like five other banks, and should want those five other banks to also do all of their trading with it and each other, and thus badness self-fulfills. This also perhaps helps explain S&P’s view on the Volcker Rule: things that tend to reduce the size and systemic-plumbing importance of banks increase the chances that those banks will be able to quietly sink beneath the waves; things that preserve or concentrate that size and importance enhance the banks’ safety from the perspective of their creditors (only?). There’s a systemic as well as a revenues argument that circa-2009 banks are less likely to default on senior debt than are their circa-imaginary-strict-Volcker-Rule successors.
If you were building a world from scratch you might do things like wall off market making from deposit banking and make sure that all banks were small enough to fail. Or you might not, I don’t know, Jamie Dimon sure doesn’t think so and he’s pretty smart. But whatever, the point is, you’re not building a world from scratch. If you slice off portions of actually existing banks, that will hurt them, and they will cry out, and the people who are narrowly focused on their credit risk – their fellow-bank counterparties, their rating agencies – will cry out along with them. (Especially if they have their own additional self-interested reasons for opposing bank-slicing.) And they won’t really be wrong! Totally demolishing banks’ market making business probably would destabilize them, at least in the short term. So S&P should be relieved that it seems pretty unlikely to happen.
Standard & Poor’s Warns of Possible Volcker Rule Downgrades [DealBook]
For U.S. Bank Ratings, The Volcker Rule’s Impact Depends On The Final Details [S&P]
Bank Ratings: What Determines Their Quality? [ECB via @SimonHinrichsen]
Interbank Discipline [SSRN via HLS]
1. Oh kidding kidding BRK/A isn’t really in the prop-trading business whatever.
2. I guess this isn’t really true? I’m sort of being glib with S&P’s argument in the text but like Lazard is BBB-/Ba2; actual small investment banks tend to have (1) not that much money and (2) kind of unstable revenues, so you could see why you might prefer to lend to something with a balance sheet. Even like “Wells Fargo plus prop trading” versus “Wells Fargo without prop trading” is not a no-brainer; Wells Fargo without prop trading is of course just a huge prop bet on corporate and mortgage credit, and rates, so you might prefer a big bank with smart prop trading for diversification. Like the London Whale, but without the fuck-ups. I think Lazard doesn’t map directly to like Volckerized-Goldman, and in any case much of this is sort of swallowed by the Volcker Rule actually having hedging, market making, etc., exceptions, but if like S&P you believe that those could end up being totally hollow and banks might really be prevented from hedging or market making then sure whatever you could worry.