Stress-tested capital is at the heart of modern prudential bank supervision. My new book, InStAbILItY: Booms, Busts, the Fragility of Banks, And What To Do about It, which is to be published April 20, explains why, as does retiring Fed Governor Daniel Tarullo in his parting speech given April 6th.
One of my principal worries about the effectiveness of the stress-testing regime is its ability to deal with large trading books of some of the modern, large securities affiliates of commercial banks. Trading books, by their nature, turn over fairly frequently, which makes stress testing one day's or week's or month's portfolio relatively meaningless. Thus, depending on the size of the book relative to the size of the enterprise's capital, this defect may or may not be a very serious one.
Advocates of a restoration of a Glass-Steagall-like wall between commercial and investment banking would say such restoration would be the right way to solve the problem. The spun-off investment banking firm might be unstable, but at least the commercial bank would be free of investment banking risks.
I think that would be the wrong approach. First, it would re-create the large investment banking firms that proved most vulnerable in the GFC. They are the firms that most threatened the system. By putting them under the umbrella of bank holding companies, they have achieved a greater degree of stability. The risk that their instability will infect the stability of the commercial banks does need serious attention. But it needs that attention not because the commercial bank is so stable on its own or because all aspects of investment banking are even more unstable, but primarily because of the investment banking trading book.
The Volcker Rule was created essentially to redress that problem. The bigger the trading book-and the more open-ended its goals-the more potentially dangerous it can be to the enterprise as a whole. The Volcker rule sought both to restrict the goals of holding trading securities and the size of those holdings.
The Volcker Rule is under attack from a number of sources. Even former Governor Tarullo is being depicted as a new enemy of the Rule. But former Governor Tarullo has not come out against the Rule. He has come out against the way it has been implemented, and he has made some suggestions-in the referenced retirement speech-as to how to fix it.
I am not sufficiently expert concerning the details of implementation to offer suggestions as to which way to fix it would be best or even whether it can be fixed. I do not know whether the ambiguities of which bankers complain are natural and so difficult to clarify that one ought not to try.
But repeal of the Volcker Rule would require one of two alternative approaches in order to avoid the risks that it sought to deal with. One would be to re-institute a form of Glass-Steagall separation. The other would be to restrict the size of a BHC's trading book (including securities held for market making) by reference to the size of its total Tier I capital. If the trading book as a whole could, even in an extreme situation, wipe out only a small portion of the enterprise's total capital, then the risk would be acceptable.
I prefer the size limitation. First, it would permit the activity to continue, subject only to its risk. Second, it would permit the synergies between investment banking and commercial banking, which are important to serving large and international corporations, to continue without further restriction. Third, it would not prevent the investment banking operations from improving the profitability of the commercial banking side of the house.
What percentage of the BHC's total Tier I capital could be accounted for by the total trading book of the enterprise? I would assume that in an extreme situation, a trading book could lose 25% of its value. Therefore the capital of the enterprise should be sufficient that it would meet applicable capital requirements after such a loss. In the stress test, the severe scenario would automatically assume that 25% loss. The enterprise therefore could make size and composition of its trading portfolio as it chose, so long as it met regulatory capital requirements after assuming such a loss.
That effectively would impose a 25% leverage ratio on the trading part of the enterprise-but not on other parts.
The bottom line is that there are five options: (1) leave the Volcker Rule as it is and live with the costs and ambiguities, (2) fix the Volcker Rule so that it works as intended, (3) repeal the Volcker rule and say the heck with the increased risks to large American banking enterprises, (4) re-institute a Glass-Steagall-like separation between commercial and investment banking-or at least parts of investment banking, or (5) restrict the size of the trading book under the BHC to a percentage of the BHC's total Tier I capital-effectively giving the trading book (regardless of its purpose) a 25% leverage ratio without affecting the leverage ratio of the remainder of the enterprise.
I like number 5. It is the simplest and does the least violence to current enterprise strategies. Maybe former Governor Tarullo would like it best as well. It would minimize disruptions at Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BA) and Citi (NYSE:C), while still removing the thorn of Volcker rule ambiguity and protecting the financial system.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.