Friday, October 12, 2012

Volker Rule Still Not Making Any Sense To FLG

Felix Salmon has a post up about an IMF paper that argues banks shouldn't be allowed to trade in financial markets.

Look, FLG fully comprehends the concept that banks shouldn't be able to make risky trades for their own profit with funds that are ultimately backstopped by a government guarantee.  Moreover, he gets the logic that, "look, trading is risky and we don't want our banks to be risky."  The trouble FLG has with this is, well, reality.  Saying the Volker rule is a good idea is a lot like saying a gun that only shoots bad guys is a good idea.

We want banks to be market makers, which is to say that if you want to buy or sell a stock, bond, or other security and can't find anybody else to trade with, then you call up a big money center bank and it will buy or sell that security from/to you.  Okay, you might say.  Fine, banks can buy and sell, but only when other parties call them first.  Then we don't have the proprietary trading issue.

 Ah, but imagine that a bunch of people call up to sell some stock all at the same time.   That bank then becomes exposed to huge amount of risk related to that specific stock that they've just bought.  Prudence dictates that they ought to manage the risk of that exposure by either selling some themselves or hedging using derivatives.  And so you have a perfectly legitimate reason for the bank to initiate a trade in the market.  Salmon seems to have an issue with that because, as FLG has argued again and again, where you stand on what is hedging versus what is speculation depends on where you sit.

According to Gongloff, the IMF paper says that banks “should be allowed to hedge their bets” with “small trading positions”. But hedging is trading — as we saw, most clearly, at JP Morgan’s Chief Investment Office. And trading is just as dangerous when it’s done for hedging purposes as it is when it’s done for absolute-return purposes.

In an ideal world, then, banks simply wouldn’t be allowed to trade at all. What’s more, in that world the banks would quite possibly make more money than they’re making right now. But you’d need globally-coordinated regulation to get there, and it’s simply not going to happen. Which is why trading blow-ups are here to stay — and regulators are always going to be on the back foot when it comes to trying to prevent them.
 The issue, as FLG sees it, isn't about some sort of zealous stance that banks ought to be barred from trading in the financial market.  In fact, the idea sounds completely ludicrous to FLG as he types it.  Rather, the issue is, as FLG has been arguing for years and years, to limit the amount of leverage to contain the damage of inevitable trading blow-ups. 

Nothing in life is risk free, it's about managing that risk.   Banks argued that they were in a better position to manage their risk.  An argument that made sense, but ultimately proved false.  Rather than getting into nitty-gritty details about whether banks can make this trade or that trade, better just to acknowledge regulators can't ever keep up, don't necessarily need to keep up, and that they just need to proscribe the size of the sandbox the banks can play in.   Systematic risk is the name of the game, not the internal risk of any particular bank.

A bank blows up its sandbox, then, well, it blew up its sandbox.  Maybe the other banks will need to lend them some sand or maybe that sandbox gets demolished, but the other banks are still playing just fine in their own sandboxes.  No need to have a bunch of near-sighted lawyers standing around with clipboards asking each bank about why it's digging in that corner or using that shovel.

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