Last week, we suggested that big banks were going to get even more opprobrium heaped upon them than the President’s “responsibility fee.” This week, that’s happened and then some. The Administration’s new initiatives make more than clear that the White House has moved far afield from its initial, relatively gentle approach to the regulatory rewrite. Some attribute this solely to politics in the wake of the Massachusetts race, and there’s certainly a strong political tone to recent actions. However, as we look at what’s now on the table, the combination of politics and policy will, we think, make the proprietary-trading proposal a particularly potent one. Of the three new ideas – the crisis fee and the liability-size cap being the other two – the ban on non-traditional investments has real legs.
Since we like policy best, let’s look first at why policy arguments will advance the proposed limitations on non-customer proprietary trading and the ban on bank affiliation with hedge funds or private equity (PE) firms. The “Volcker Rule,” as it’s now been dubbed, is supported not only by solons like the former FRB chairman , but even by the Wall Street Journal – not exactly bastions of socialism. This gives the idea considerable credibility, like it or not.
There are three major concerns underpinning the Volcker Rule: earnings volatility, conflicts of interest and risk. We’ll go through each of these and then turn to politics.
Earnings volatility is perhaps the easiest concern to counter. Regulatory capital is intended to address this risk by imposing a buffer against loss. To date, there’s been no meaningful regulatory-capital requirement on the trading book of large banking organizations. That’s about to change, with a new Basel rule finalized last year that would more than triple market-risk capital and correct at least some of the flaws in value-at-risk modeling. To be sure, the industry has launched a fierce fight against these rules and they’re not even in proposed form in the U.S. However, they are coming and thus permit banks to claim with justice that non-traditional wholesale activities will soon come under a tougher prudential regime that addresses at least this aspect of their critics’ concerns.
Conflicts of interest are harder to counter, especially now that Goldman Sachs has made itself the poster child on this sore point following disclosures of how it bet against its customers. However, even if the industry foreswore this practice, risks would remain. If banks bet with their customers, then they are taking what’s called wrong-way risk – that is, they are doubling down their risk by aligning it with customers so that when customers lose, the banks do too. If banks bet against their customers, then they minimize wrong-way risk, but they are engaging in a new form of insider trading that brings us right back to the conflict of interest problem.
And, even if new policies and, maybe, some limits address conflict of interest, there’s risk. Goldman Sachs has somehow managed to make itself the poster child here too. When we listen to it talk about how no one should worry about the risk of its proprietary trading because it knows how to do this, we’re reminded of Fannie Mae. Clients will recall that it too told regulators not to worry because its risk management was above reproach. We’ll posit a simple rule to add to the Volcker one: any firm that thinks it’s smarter than everyone else is setting itself up for a fall and, if it’s of systemic size, positioning the rest of us for a costly rescue. We know that proprietary trading and hedge-fund/PE investments didn’t cause this crisis, but their size at some firms and risk – that’s why they can be so profitable – mean they well could lie at the heart of the next go-round with global chaos.
But, even if the industry beats back all these policy problems – heavy lifting – there’s still the politics of the Volcker Rule with which to reckon. This too is a formidable challenge. A lot of hedge funds, PEs and big-bank competitors want banks out of their business. Bank core funding and capital-market access has long given Goldman Sachs and, to be fair, every other banking organization a big edge over non-bank firms. That’s why some of the bigger ones pushed more vulnerable banks out of the hedge-fund and PE arena five years ago. With the Volcker Rule’s wind behind their sails, they’ll mobilize a skilled lobbying campaign against the banks. With some of these firms located in key states – Connecticut among them — this is a serious political counterweight that adds a lot of heft to the policy problem.