Now that we see big banks quickly developing ways to sidestep some of the financial regulation enacted by Congress this summer, the public outrage is starting to heat up. The New York Times stokes the fire today, with an article explaining that Wall Street banks are exploiting a loophole to avoid the Volcker Rule's ban on proprietary trading. Should we be angry? Perhaps, but any criticism should be directed at the rule, not the banks.
About a month ago I wrote about the strategy today's Times' article explains. So see this post for a refresher. The essential idea is that if the banks can specifically identify a trade as being for a client, then they can claim to wear the market-maker hat, instead of the prop-trading hat. The Times provides an example:
This year, for example, several large insurance companies approached Goldman Sachs, looking to bet that the markets would not stay quiet. Goldman gladly took the other side of the trades, but when the markets turned choppy in May, the firm was caught short and quickly lost $250 million.
The "other side" of the bet is what might have been considered prop trading. But in this case, Goldman was fulfilling the order of a client, so it can also be classified as a case of the bank acting as a market maker. The question, then, is whether we should be outraged if banks are still able to make bets for their own profit if it is in the context of making a market for a client.
Back when the Volcker Rule was unveiled earlier this year, it was pretty clear why everyone should find the practice objectionable. It was portrayed the banks using customer deposits without their consent to make sometimes risky bets that would boost the bank's profits.* This conjured up images of fat cat traders sitting around making wild predictions about the future, and then reaching into their customer deposit base to use the life savings of firemen and teachers to wager on some crazy hunch.
But that isn't what's happening in example above. Clients came to Goldman, and the bank took the other side of the trade. It's pretty hard to get angry at this kind of behavior for two reasons. First, the bank is acting as a market maker, which is precisely what it's supposed to do. Second, it didn't initiate the trade -- a client did.
So this example is pretty easy to brush off, but can we generalize this acquiescence to all cases where a trade can be classified as client-related? Imagine the situation above was the same, but instead Goldman had a hunch that the markets would stay quiet and approached the insurance companies. The insurance companies can still be considered clients, so the classification can remain the same, but this time the bank initiated the trade.
Unfortunately, there's not an easy way to avoid this potential problem. Perhaps you think the law can just be changed to forbid banks from initiating trades. But that completely misses the purpose of the Volcker Rule -- to reduce the magnitude of the risks banks take. If a bank only accepts the trades initiated by others, then it won't be able to solicit bets that it independently determines have a high probability of success. In other words, it will be stuck only taking the other side of trades that other people have thought about very carefully. This would probably result in even greater losses than if the bank had diversified its portfolio with bets that its own analysis suggests will be profitable. Because remember: banks also couldn't hedge under this criterion, since that would mean it is initiating a bet on its own behalf.
And of course, the only other option would be to simply forbid depository institutions from making markets entirely. The Volcker rule alone can't do that -- you would essentially have to repeal Glass-Steagall and split up banks' depository and securities divisions. But there's no reason to believe that this would have solved the problems that arose during the financial crisis, considering that many of the market's deepest problems were caused by pure investment banks like Bear Sterns and Lehman Brothers. And obviously you can't forbid investment banks from making markets, because that's precisely their purpose. Moreover, the depository institutions didn't get into trouble due to prop trading: they had huge losses due to writing bad loans.
So if there's any criticism that should arise from the new tactics being developed by banks to escape the Volcker Rule, it shouldn't be directed at the banks: it should be directed at the rule. It was flawed from the very beginning, because it's not really possible to clearly distinguish prop trading from other market-making. It may have attempted to act as a proxy for Glass-Steagall, but it fails to do so.
* Which, of course, sounds an awful lot like the kind of lending banks have been doing since the beginning of time!