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21st Century Glass-Steagall
So there’s now word that, following the advice of former Federal Reserve Chairman Paul Volcker and others, President Obama will move to take a stronger position on financial sector regulation. From the New York Times:
…The president, for the first time, will throw his weight behind an approach long championed by Paul A. Volcker, former chairman of the Federal Reserve and an adviser to the Obama administration. The proposal will put limits on bank size and prohibit commercial banks from trading for their own accounts — known as proprietary trading….
“The heart of my argument,” Mr. Volcker said, “is who we are going to save and who we are not going to save. And I don’t want to save what is not at the heart of commercial banking.”
Mr. Volcker has been trying for weeks to drum up support — on Wall Street and in Washington — for restrictions similar to those passed in the Glass-Steagall Act in 1933. That law separated commercial banking and investment banking, so that the investment arm could no longer use a depositor’s money to purchase stocks, sometimes drawing money from a savings account, for example, without the depositor’s knowledge.
Simon Johnson has follow-up questions.
I’ve been thinking a lot about this approach as a major piece of regulating the financial sector. The point isn’t to simply redo what we’ve already done, because markets change and our government’s approach to them needs to change as well. There’s an argument that the old conflict between commercial and investment banking is gone, and that having these two types of business lines together now actually creates stability for the firm itself. So the idea is to take the spirit of what has worked in the past and update it to new challenges, and in this sense I like to think of this as a “21st Century Glass-Steagall.”
Prop Trading
Prop Trading is when a financial firm uses its client’s deposits or borrowed money to invest for its own profit. What many financial institutions have decided to do is take a normal business line and plop a hedge fund in the middle of it. The boring insurers AIG are the leading example of this, but it is everywhere. Many of these hedge funds do very complicated, highly leveraged bets: they bet spreads on bonds will converge a penny, like Long Term Capital Management did; they bet you’ll see short-term mean reversion in stocks; they bet that after an earnings announcement by a company there will be “drift” in the stock price for an additional week. (There’s more – we haven’t even gotten to volatility estimates.) Chasing these statistical ghosts are all worth a penny or two, but if you are highly leveraged that can be a lot of money earned or lost quickly.
Or they can be doing normal gambling in the marketplace, buying financial instruments that they think will go up or down. Since they are also trading for clients, there is that awkward conflict of interest problem, where you may ask them to underwrite something, or trade for you, and they can also trade themselves ahead of your information.
Here’s the question: Should we as taxpayers provide a safety net for either of these activities? I’ll leave it up to you as to whether or not prop trading makes markets a better thing; to the extent that it does it is certainly well compensated, and well provisioned for by the private market. What we don’t want is internal hedge funds to be leveraging up and gambling using money that comes with a safety net for preventing devastating bank runs that is provided by taxpayers. In any institution, but especially financial ones, money is fungible. So putting up “walls” to silo off these different functions within one company won’t help us – we actually need to spin these functions out.
Conflicts, Other Pieces Needed
And the separate but related question of conflict of interest will be interesting: During the first FCIC hearing last week, Angelides grilled Goldman Sachs CEO Blankfein about whether or not there was a conflict between Goldman’s market making and prop desk and their underwriting desk. Blankfein said no, these are never in conflict, while Angelides clearly thought they did. I will withhold saying more until I learn about the press conference, but how these types of conflicts of interests are separated out will be a major piece of concern for financial reform, and something that should be clarified today.
So as we discussed in the previous entry, this is a simple and elegant solution. There’s no raising a “rainy-day” TARP-esque fund. There’s no trying to second-guess the proper limits for trading for profit within a commercial bank. If you want to be in that space, and get the safety net and stability that comes with it, you have to accept simple terms.
Because if a commercial bank fails, it has access to government mechanisms through the normal FDIC channel. If a prop-trading investment bank fails, it should be wound down in accordance with new financial firm bankruptcy rules. Now note we have to move two other piece of reform in order to make this credible: we need a system where parties are aware of the derivatives holdings of an investment bank pre-crisis, say through a clearinghouse or exchange, so to make resolution credible and prevent panics. We also need a new resolution authority to handle these firms in a manner that won’t destroy the system. Regulating exchanges, and special bankruptcy proceeding for financial firms: we’ve done this before in the New Deal, we just never upgraded it for a new century, and right now a broken financial sector calls again for these changes.
Rortybomb 
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Today was like one of those fly dreams
I got to say it was a good day
Finally some non-disappointment from the Obama administration. At least Guantanamo is still open a year later so we can put Haitian refugees there, right?
I think the revival of Glass-Steagal is progress, but I don’t know that it is foolproof. Two issues, interest rate risk in the Savings and Loan crisis, and massive risky loan portfolios in the current crisis, both remain unresolved. If banks borrow short and lend long, then they can still have a crisis due to interest rate mismatches, like in the S+L crisis. Also, banks can still make plenty of risky housing loans.
Basically, eliminating exposure to equities and other risky activities of investment banks is progress for commercial banks, but there is another risky equity class that commercial banks have large exposure to: housing. I really don’t know how to resolve that, but I think that Wamu would still have gone under even if Glass-Steagal had been around in the 00s.
In any case, today is major progress.
Obviously this is a full employment act for regulators and cover for continued sponsorship of favored financial firms/industries.
Consider a scenario where a bank buys Fannie Mae mortgage backed bonds. It then makes new mortgage loans for its books and sells some of those bonds to fund the mortgages. If it books a gain are those proprietary trading profits?
In another scenario a bank participates in a loan syndication and then sells its participation later for a loss or profit. Is this proprietary trading?
The possibilities are endless and this regulation shows the hubris of Volker, Obama and other regulators who think they can control the system with “smart” regulation. It’s a perpetual game of “Whack a Mole” when the government backstops favored industries or companies. The real reform would be to end government sponsorship of financial firms.
P.S. Volker said: “And I don’t want to save what is not at the heart of commercial banking”.
As a former banker, I always believed banking had a special place in the economy and needed government backing. Now I ask WHY!!!! Well, mainly because everyone’s on the same side of the trade. The FED made $45B last year. Even the regulators are profitting from the current system….
Ok, but do you think we can get a 21st century Glass-Steagall with corporations new ability to threaten and bribe politicians, and with the filibuster?
It looks like now the most important goal — because it’s so pivotal to achieving every other important goal — is abolishing the filibuster and very large public campaign finance, as I wrote in my post last Sunday even before our country took the wrenching blows of the last two days.
“Prop Trading is when a financial firm uses its client’s deposits or borrowed money to invest for its own profit. What many financial institutions have decided to do is take a normal business line and plop a hedge fund in the middle of it. The boring insurers AIG are the leading example of this, but it is everywhere.”
Umm what? Firms using clients money – that is money management, the bank wouldnt be at risk. The bank woudl take a fee for a service. Using borrowed money, ok isnt that what GE did and they didnt have any trading desks. Is the massive lender known as GE Capital an embedded hedge fund? As for insurers, this is a non-sequiter. By definition an insurer is a risk-taker. All insurance cos are basically the same as hedge funds but take specific, generally non-hedgeable or illiquid risks with the cover of a regulator to protect against adverse mark-to-markets. AIG-FP wasnt unique to AIG in what it did, but rather how it did it.
it goes way beyond commercial banks and Glass Stegall though – we really need to limit leverage. if i have to post 50% margin in my Etrade account, how come Long Term Capital can blow up the markets with 1% margin? THAT is the problem – margin and leverage no matter who is doing the trading! In other words, even if we just re-enacted glass-steagall, we need to make sure that the investment banks, when things go bad, lose only THEIR OWN money, not everyone else’s money…
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I hate to publicly declare that a major public figure is lying, but as a long-time institutional investor, I must say that Mr. Blankfein and other leaders of the banking industry are at the very least being economical with the truth. Everyone knows that bankers’ trading desks position themselves against clients, especially when they are sponsoring a major underwriting. Everyone knows that they cannot trust their stockbrokers and their analysts any more; this is why institutional investors have spent hundreds of millions increasing the size of their in-house analytical staff.
Unfortunately, not only does the creation of such a huge staff dilute the pool of available talent, it also does not ameliorate the problem that such analysts do not have direct access to the marketplace and therefore can only judge the fundamentals of an investment opportunity according to an abstract standard. In short, Wall Street analysts used to perform an invaluable and irreplaceable function that is no longer being performed because all of the major stockbrokers are now components of integrated investment banks, which earn far more from underwriting new issues than they do from agency broking (which has become a loss-leader).
Then there are the banks’ in-house fund management operations, which have also been known to stuff their clients with securities they would not otherwise have bought, in order to cement a relationship with a corporate client, woo a prospective corporate client, or help out an underwriting that is in trouble. These are fundamental conflicts of interest, which would inevitably occur even if the organization were somehow able to keep its traders from front-running a major order, or ‘conditioning’ the market in behalf of an especially good broking client (usually a hedge fund nowadays, as these are such a huge source of commissions.)
Next, let’s talk about conflicts that arise from the universal banks’ situation as transfer agents and custodians of securities who often provide stock loans (of clients’ shares, not just their own) to their trading desks both to support their own proprietary trading activities and to facilitate the construction of derivative positions for their hedge fund clients. They determine the rates paid on securities loans and implicitly, the difficulty any traditionally long customer will experience upon attempting to ‘recall’ the loan (i.e., be bought back in.)
This is before one examines the economic logic of having government-backed entities, using insured deposits, to speculate upon markets, entirely for the benefit of the desk doing the speculating. Sure, they claim to have ‘Chinese Walls,’ and they even have a few compliance people to try to enforce them. Any desert nomad who couldn’t figure out how to get through these Chinese Walls doesn’t have the IQ necessary to get a job on the janitorial staff, let alone a responsible position in an investment bank.
When the big Wall Street firms, already riven with conflicts, began to merge with other financial organizations, and later with commercial banks, they always made sales pitches to us as investing institutions, telling us how their increased capital base could be put to work in our behalf as brokerage clients. They made the same pitch to their corporate clients. Twenty-five years on, clients are still waiting to find out how this increased capital will help them. What it has done is to put what used to be a hundred-odd competing organizations in the U.S., and perhaps a thousand world-wide, into an oligopoly of one or two dozen conflict-ridden universal banks so entangled with the ordinary flow of capital around the world that governments must prop up each and every one of them to prevent a melt-down of the entire system.
Risk-taking is a necessary part of any business, and the financial system is no different. But to claim that those who run the greatest risks must be protected from the consequences of their mistakes by taxpayers the same way that most ordinary, low-risk financial transactions need to be protected flies in the face of every form of logic, as well as three-hundred-odd years of financial experience.
Major risk-takers should be isolated in specialist partnerships, where they gamble only with their own money. More typical and socially-useful risk-takers (underwriters, insurers—including creators of derivative positions to hedge against risk, fund managers) should probably be herded into distinct organizations where conflicts of interest are less likely, and where the shareholders of the organization alone bear the risk of failure. Commercial banking, the guardianship of the vast amounts of capital necessary for the ordinary transactions, demand deposits, term loans, and financing of asset-backed transactions, should go back to being the risk-averse activity it traditionally has been.
The providing of electricity, gas, and water to businesses and households long ago ceased to be an exciting activity because it became too essential to our continued survival as a society to allow anyone to have fun manipulating the companies performing these services. The flow of basic money is no less essential to our continued functioning as a developed society, and should be subject to the same restrictions.