It seems that Obama has come around to Paul Volcker’s position that “protected” financial institutions must not be allowed to take on proprietary risk. In this interview in Der Spiegel, Paul Volcker argues that banks must not be allowed to take on proprietary risk except for risk incidental to “client activities”. Quoting from the interview:
“SPIEGEL: Banking should become boring again?
Volcker: Banking will never be boring. Banking is a risky business. They are going to have plenty of activity. They can do underwriting. They can do securitization. They can do a lot of lending. They can do merger and acquisition advice. They can do investment management. These are all client activities. What I don’t want them doing is piling on top of that risky capital market business. That also leads to conflicts of interest.”
This is a more nuanced version of the argument that calls for the reinstatement of the Glass-Steagall Act. But it suffers from two fatal flaws:
Regulatory Arbitrage: Separation of “client risk” and “proprietary risk” sounds good in theory but it’s almost impossible to enforce in practise. As I’ve discussed previously, a detailed and fine-tuned regulatory policy will be easy to arbitrage and a blunt policy will result in a grossly inefficient financial system.
Losses on “Client Activities” were the major driver in the current crisis. My analysis of the UBS shareholder report highlighted how the accumulation of super-senior CDO tranches was justified primarily by their perceived importance in facilitating the sale of fee-generating junior tranches to clients. Quoting from the report: “within the CDO desk, the ability to retain these tranches was seen as a part of the overall CDO business, providing assistance to the structuring business more generally.” It is the losses on these tranches issued in the name of facilitating client business that were at the core of the crisis. It is these tranches that caused the majority of the losses on banks’ balance sheets. It is losses on insuring these tranches that brought down AIG. Segregated proprietary risk is monitored closely by almost all banks. The real villain of the piece was proprietary risk taken on under the cover of facilitating client business.
Implementation of the Ban
Clearly a simple ban on internal hedge funds and proprietary trading desks would not work. All banks trade the same product on their client’s behalf that they do on a proprietary basis and such a ban can be nullified simply by folding all proprietary operations into trading desks that also facilitate client business.
Another alternative would be to enforce market risk limits on banks, based on VaR for example. If VaR was the criteria in enforcing risk limits on banks in the previous crisis, the crisis would not have been averted. The super-senior CDO tranches at the heart of the crisis were low VaR assets on their own and “zero VaR” assets when merely delta hedged without any hedging of higher-order risks.
Again quoting from the UBS report: “MRC VaR methodologies relied on the AAA rating of the Super Senior positions. The AAA rating determined the relevant product-type time series to be used in calculating VaR. In turn, the product-type time series determined the volatility sensitivities to be applied to Super Senior positions. Until Q3 2007, the 5-year time series had demonstrated very low levels of volatility sensitivities. As a consequence, even unhedged Super Senior positions contributed little to VaR utilisation.” “Once hedged, either through NegBasis or AMPS trades, the Super Senior positions were VaR and Stress Testing neutral (i.e., because they were treated as fully hedged, the Super Senior positions were netted to zero and therefore did not utilize VaR and Stress limits). The CDO desk considered a Super Senior hedged with 2% or more of AMPS protection to be fully hedged. In several MRC reports, the long and short positions were netted, and the inventory of Super Seniors was not shown, or was unclear. For AMPS trades, the zero VaR assumption subsequently proved to be incorrect as only a portion of the exposure was hedged as described in section 4.2.3, although it was believed at the time that such protection was sufficient.”
To summarise, it is extremely unlikely that there exists a way to ban proprietary risk-taking that cannot be circumvented by the banks.