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Proprietary Trading Ban: Is It A Good Idea?

Proprietary trading is an easy target for politicians in the current environment. But is banning it the right thing to do? Will such a ban limit systemic risk? Will it strengthen our financial system? Will it reduce the danger of public money being diverted to subsidize private risk-taking? Will it trigger unintended consequences? Will it help or hurt retirees and other people who depend on robust capital markets for their sustenance?
 
First of all, it needs to be acknowledged that Paul Volcker and others who argue for the ban make a cogent case on at least a theoretical level. Prop trading as practiced by modern financial institutions is a capital-intensive business. Those firms which benefit from federal deposit insurance gain privileged access to capital which in the best of worlds would not be allowed to subsidize unsupervised risk-taking. And while most prop trading does not occur within insured banking subsidiaries, money becomes a fungible resource within a bank holding company structure. Prop trading activities within these big families gain leverage from indirect access to insured deposits. Furthermore, proprietary trading at its worst exposes institutions to life-threatening risks. A large bank whose business has been supercharged by indirect subsidy gets to dig more directly into the public till when the trading game blows up with enough concussion to require a bail-out.
 
At this level, the case for banning proprietary trading seems overwhelming. Politicians considering legislation often have little incentive to look much beyond headline logic, and the headline logic here is all in one direction. Legislators supporting such a ban are protecting taxpayers from reckless gambling at their expense. Those questioning the idea are in thrall to special interests. So what posture does a careful politician adopt? Facing such a stark choice between apparent good and evil, our legislators can perhaps be forgiven a degree of shallow thinking here.   
 
The rest of us, however, should indulge in the luxury of looking a little deeper. As rational investors, and as citizens, we in fact have an obligation to do so. Is banning proprietary trading really the slam-dunk case it might appear to be.
 
I think it is not. But then where exactly does that leave us on the issue?
 
First of all, we need to establish the point that proprietary trading was not the primary or necessarily even a leading cause of the 2008 financial crisis. In fact, the crisis originated in the breakdown that occurred in one of the most traditional of banking businesses: the extension of mortgage credit. The failure was, of course, ultimately caused by the engineered convergence between this business and structured finance. The design and placement of structured mortgage securities, however, does not constitute proprietary trading in any meaningful sense of the term. This is a semantical point, but semantics matter a lot here when we're talking about concepts that may soon be hardcoded into the language of law. If the purpose of financial reform legislation is avoiding a replay of the 2008 tribulation, proprietary trading is probably an empty target.  
 
The second obvious problem is the fact that no definition of proprietary trading is possible that distinguishes it with actionable specificity from the normal trading activities essential to healthy capital markets. What we now refer to as proprietary trading had its origins in the functions established many years ago by investment banks when they realized the need to make markets in the stocks and bonds they underwrote. Such market-making offered liquidity to investors and encouraged the flow of investor capital. The investment banks then found themselves with balance sheet commitments too large to be supported prudently by their smallish capital. Hence, active trading techniques were developed to manage the exposures and control the risk.
 
Unfortunately, active risk management easily morphed into its opposite in many cases, and the prop trading dragon was out of its cage. The danger now is that heavy-handed attacks on it run the risk of attacking the capital markets themselves and undermining the liquidity that makes them possible. The fact that the prop trading ban is apparently being proposed only for insured deposit-taking institutions leaves open the question of how such precision targeting could be instituted within the current structure of our financial services industry. Addressing that question opens up bigger questions that are, to borrow phrase from President Obama, above my pay grade. The problem is that they are also probably above the pay grade of the bureaucrats who would be called upon to execute the task.
 
This then leads to the biggest difficulty with the idea to ban proprietary trading: the canyon-sized gap that exists between the idea itself and the probable manner in which it would be implemented.
 
There are two stages to this problem, the first stage being how the idea - which its proponents have fairly articulated - will translate into the language of law. It is inevitable that this language will be broad and open to considerable interpretation. The second stage then, the most important one, involves how regulatory personnel will understand and enforce their mandate. The vaguer that mandate, the greater the danger that regulators will feel empowered to enforce changes on the capital markets that go way beyond what might have been imagined in the enabling legislation. It's the nature of government regulation in general the regulatory bureaucracies live on long after the politicians who create them are gone from the scene. As capital market investors, we need to be wary of the hazard here.
 
Once again, I understand and fully accept the point that subsidized institutions in general are abusing their privilege when they engage in proprietary risk-taking. But since I can't imagine how either the subsidies or the risk-taking can be prudently removed from the system at the present time, I believe this to be a contradiction that we're going to have to learn to live with for the foreseeable future.  


Disclosure: No Positions

Disclosure: No Positions