Sheila Bair Doesn't Know What The Volcker Rule Prohibits

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Sheila Bair, former head of the FDIC and cartoon-klutz-villain of Too Big to Fail, comes in for the occasional gentle ribbing on Wall Street, and her column in Fortune today is well set up for another round of gentle ribbing, which I will get to in just a minute, so you might think that that headline was intended to make fun of her, but actually, no, she makes a solid point:

MF Global took proprietary positions in European sovereign debt through what Wall Street calls "repo to maturity" transactions. It technically sold the European bonds to other firms, agreeing to repurchase them at a premium when they matured in 2012. MF hoped to make money by pocketing the difference in the rate it paid its trading partners and the higher rate paid on the bonds themselves. ... Under the 300-page Rube Goldberg contraption of a regulation recently proposed by federal agencies to implement the Volcker Rule, "repo" transactions like MF Global's are not generally treated as verboten proprietary trades. Thus, even if MF Global had been a bank, it arguably could have used this exception to gamble away, putting the FDIC at risk.

Now, if I had to guess, I'd say the better side of the argument is that the MF sovereign trades would in fact be streng verboten under the Volcker Rule. (Except, of course, as she points out, that MF is not an FDIC insured bank and so is not covered by the Volcker Rule.) I read the rule's coverage of "any long, short, synthetic or other position" in a security to include the Corzine repo-to-maturity, which is at least a "synthetic position" in the underlying debt, and since the position seems to have been more "prop" than "flow" it would probably be prohibited. But I had to search around in the proposal for some time to come to that conclusion - it's not apparent even from the mammoth Davis Polk flowchart that has replaced the actual rule text for my day-to-day Volcker Rule pondering efforts. And the meaning of "synthetic" may not be the same to everyone. So I'll spot her the claim that a bank could "arguably" use a repo-to-maturity structure to prop trade to its little heart's content. [Update: A lawyer I trust points to the Volcker Rule's "repo exception" for trades arising out of repo agreements; he thinks that Bair is right that the MF Global trades would fall under the exception and not be covered by the rule. I suspect that the intent of the "repo exception" is to cover the people providing the repo funding (here MF's counterparties), not the people with economic exposure to the position, so I'll tentatively stick to my original claim, but in any case the murk is even murkier than I'd thought. By the way, if I'm wrong, then things are even worse than Sheila Bair thinks. Basically any prop trade is fine as long as you fund it via repo.]

Regardless of whether she's right on the technical argument, the broader point that it illustrates is well-taken: it is not easy to figure out what the Volcker Rule says about a bunch of the activities regularly conducted by US banks. Drawing the line between "socially valuable financial intermediation" and "dangerous prop trading" will never be easy, because the actual economic and substantive line between them is blurry. I happen to think the Volcker Rule draft is a decent stab at that hard definitional job, but Bair's more skeptical view is plausible.

What to do about that? Here is where things get a little weird:

So here is an idea. Regulators should scrap the mind-boggling complexity in the proposed rule and focus instead on the underlying economics of a transaction. If the transaction makes money the old-fashioned way -- the customer paying the institution for a service through interest, fees, and commissions -- then it passes the test. If profitability (or loss) is driven by the direction of markets, then it fails. Inevitable gray areas, such as marketmaking, need to be done outside of the insured bank and be supported by a truckload of capital.

So, yeah, I kind of get that intuition. The average human probably does experience a bank more or less as a service provider that charges fees. Chase does me the services of keeping my $20 bills in a shoebox with my name on it and employing a team of couriers to magically whisk those $20s to ATMs across the world at the exact moment that I need cash. In exchange, it charges me like $2 for going to one of the four ATMs in New York not owned by Chase. These activities would presumably be allowed under the Bair Rule.

But Chase also wrote me a mortgage, and - and perhaps I am unusual in this - I don't experience that as a "service." I experience that as "money." That they gave me. And that they'd like me to pay back if at all possible. With interest.

Chase, meanwhile, experiences that mortgage as an asset. On its balance sheet. (Well, not now, but in the Bair Rule world.) Which earns interest, yes, but which also has a calculable market value. Chase doesn't calculate that value, natch, but it could if it wanted to - because it is exposed to interest rate risk, inflation risk, "he left investment banking to do what?" risk, etc., and those risks can at least in theory be reduced to some effect on market value.

If you were working from a blank slate, and someone came to you and said "which is more likely to blow up the financial system: banks investing their money in the short-term debt of large European governments, or banks investing their money in a 30-year note of some guy who writes nonsense on the internet?," you - I mean, you'd at least have to think about it, right?

Banks don't make profits or losses by risking their capital to own financial assets as part of a "gray area" that's a sidelight to their basic traditional fee-charging business. Risking capital to own financial assets is their business. (The fees are the gray area.)

I don't want to overstate this too much. There's a real argument that direct lending to people and companies is a more socially valuable purpose of banking than investing in the secondary market. And to the extent Bair means that banks should not be in the business of risking their capital on market-driven, short-term assets, but should rather be in a lifetime relationship with borrowers and should hold loans to maturity rather than securitizing them and all that Bedford Falls-ery, sure, okay, that's a normal position. It might be a little late to turn back the clock on that, but the generally increasing velocity of all things financy does worry lots of people.

On the other hand, the Volcker Rule bans socially beneficial (maybe?), primary-capital, hold-to-maturity private equity investing by banks. And remember that the profitability of MF Global's European trades weren't supposed to be based on market values - they were hold-to-maturity bets where MF's profit was based on old-fashioned interest. And they would have worked, too, if it weren't for that meddling bank run / increased repo haircut.

Over all the notion that the path to safety for banks is to turn them into a service business seems misguided, coming from a place of consumer-finance rhetoric rather than serious thinking about the purposes of a financial industry. The point of a bank is not to reduce credit card fees and clearly disclose mortgage terms, but to provide credit. And the idea that "focusing on the underlying economics of a transaction" can distinguish between a loan and a bond - or a residential mortgage and an RMBS - severely undersells the ingenuity of the financial sector.

Bair is probably right that the distinction between "prop trading" and useful activity drawn by the Volcker Rule does not prevent banks from doing all manner of risky things. It wasn't really intended to: "prop trading" sounded sort of nasty, and people made money doing it, and we'd had a financial crisis, and a futile and stupid gesture was required, so presto, Volcker Rule. But that's because clearly drawing that line is really hard, and replacing the line drawn by the Volcker Rule - in one sentence ("no prop trading") or 300 pages - with another arbitrary one-sentence definition is equally unlikely to work.

Sheila Bair: We need a new Volcker rule for banks [Fortune]