An Interview with Jane D’Arista on the Volcker Rule

In addition to off-balance reform, I wanted to do an interview about the Volcker Rule that is proposed with Senator Merkley’s amendment.

Jane D’Arista is a research associate at PERI and the co-coordinator of the Economists’ Committee for Stable, Accountable, Fair, and Efficient Financial Reform (SAFER). We both participated in a conference call hosted by Senator Merkley you can listen to here. (Senator Merkley knows his stuff.)

If you check Jane’s EPI Page, she wrote a paper in 1993 called The Parallel Banking System. Here’s the summary:

Over the last two decades, the U.S. system has been reshaped by the spread of multifunctional financial conglomerates and the emergence of an unregulated parallel banking system. Along with other powerful trends like securitization, these events have broken down the carefully compartmentalized credit and capital marketplace established in New Deal legislation 60 years ago.

Today, a variety of unregulated financial intermediaries operate on the fringes of the financial system…Similarly, finance companies anchor the lending side of a parallel banking system. The finance companies obtain their funds from banks as well as from the money market mutual funds (MMMFs) that buy their notes, banks, and commercial papers. Measured in terms of their aggregate assets and the size of individual companies, finance companies rank as the largest single group of unregulated intermediaries.

Because of their size and their ability to lend to businesses as well as to household borrowers, finance companies affect credit markets more than do other types of less-regulated intermediaries. Finance companies are the most important nonbank intermediaries because they function like banks with virtually no regulatory costs.

Which is to say Jane called the shadow banking problem in 1993. So I was curious to get her opinion on how the Volcker Rule could make the financial system stronger.

Mike Konczal: Prop trading. What is it, who does it and why do they do it?

Jane D’Arista: Proprietary trading is the name for trades that banks make for their own accounts, not for their customers. It’s done by the largest banks and investment banks, but also by any sizable institution that can access the repurchase agreement (repo) market and borrow the funds needed to buy assets or take derivatives positions that generate profits for themselves. There is no economic benefit. And it is risky. Prop trading only works if they can borrow enough to substantially leverage their own capital. They have to set up a situation in which the cost of borrowing is lower than the return on the assets or derivatives in which they are investing. One example is what they are doing right now – borrowing very cheaply from the Federal Reserve and earning 200 basis points, let’s say, on buying Treasury securities. The name for that is the carry trade and it guarantees a nice income unless there’s a sharp change in interest rates that puts the position under water.

Prop trading is not just a domestic game. Banks also borrow in one currency (with a low interest rate) and invest in assets denominated in another currency with higher interest rates. The return can be even larger on cross-border carry trades because when the traffic going one way is heavy enough (as in the yen/dollar carry trade in 1998 and 2005), selling the borrowed currency to buy the one in which the banks want to invest causes the borrowed currency to depreciate while the currency purchased to make the investment appreciates. The result is both a gain on the difference in interest rates and in the change in the value of the currency.

Borrowing or lending in the repo market or the so-called euro (off shore) market involves posting collateral. A borrower uses asset on its balance sheet to back the repo and then takes the cash and buys more assets. Those assets, too, can be used as collateral for even more borrowing. Economists call this monetizing debt and the degree to which it was taken in the two years before the outbreak of the crisis in 2007 was like the unleashing of a sorcerer’s apprentice. You can see it in the growth of the balance sheets of the largest institutions. You can see it in the overall growth of the financial sector – in the jump of its outstanding liabilities from 64 to 114 percent of GDP in the decade ending in 2007. Another measure of that growth is the expansion of the repo market in the U.S. from $1 trillion at year-end 2001 to $4.3 trillion in early 2008. But this was not only a U.S. problem. Last year the bank of England pointed out that the balance sheet of the UK banking sector rose threefold from 2000 to 2007.

Proprietary trading is the strategy that inflated the profits of the largest institutions, inflated their balance sheets and helped create an enormous level of fragility. In the process of deleveraging those positions, charges against capital led to an erosion that turned the supposed cushion of capital in institutions into a conduit to insolvency.

How is prop trading related to the fragility of a firm? I would say if you have a large bank, having another source of income might diversify risk and that might make the firm more stable. Your argument seems to be that it actually makes the firm less stable and more fragile.

Yes because the only way prop trading is profitable is if the scale is enormous, especially in periods of low interest rates when margins are thin. Also because there is – has to be – a maturity mismatch to generate that margin. Except in rare periods when yield curves are inverted, low interest rates are available if borrowing is short-term lending and the desired higher rates on investment are available on longer-term assets. There is a liquidity risk if something happens in the market and the cost of rolling over the short-term borrowing rises or, in a real disruption, funds simply aren’t available. If the market gets spooked, banks may not be able to cover their positions overnight. That’s a problem that has come up frequently in the euro market since the ‘70s. Every time there’s been a shock – Franklin National in 1975, Continental Illinois in 1984, Long Term Capital Management in 1998 – one or more big institution was not able to cover its position because its short-term funding disappeared and central bank liquidity had to be rushed to the rescue.

Excellent. So this sounds very similar to arguments made by people like Perry Mehrling or Gregg Gordon about shadow banking run, that a lot of institutions instead of funding themselves through core deposits were lending long through overnight type of deposits, like repo, so what you’re saying is the prop desk is very situated at that nexus of a shadow banking run.

Yes, and there’s another side of shadow banking – the vast entity outside of national markets that we call the euro market – that has gotten little or no attention.

Now people might say if we remove the prop trading desk from the firm its no less risky because it will be outside the firm, its like were not going to make it less risky, it will just move it around. What should people think in terms of taking the prop desk out of firms that have access to the fed window?

That is a problem unless you back up the ban on prop trading by banks with section 610 of the Dodd bill. You’re quite right that the ban is limited to banks and while they got into the game somewhat later domestically, they were engaged in prop trading out there in the euro market for decades. And your question is how do you deal with the practice in other institutions? What’s important about the ban on banks is that you end the channel through which the backup to the Fed creates the moral hazard that supports excessive risk. If the amount of funding banks can supply to one another and to other financial institutions is curtailed, prop trading will have to shrink because the repo market will shrink.

That’s what section 610 of the Dodd bill would do, shrink the repo market. It would restrict loans by banks to other financial institutions, requiring that the same limit on loans to a non-financial borrower in relation to capital that has been in effect for over a hundred years also apply to financial borrowers. In the case of financial institutions, the limit would apply to credit exposures involving repos, securities purchases and sales and a very broad list of derivatives.

Excellent, so can you tell me a little bit more about section 610?

At a recent conference, Richard Carnell mentioned that the Comptroller of the Currency made a decision toward the end of the ‘90s to exempt financial institutions from the National Bank Act limits on loans to individual borrowers. It was never in the act before because borrowing among financial institutions was not extensive. But the growth of the offshore banking market and the invention of the domestic repo market dramatically raised the amount of intra-sectoral borrowing and brought the issue into focus. The result was the decision not to include financial institutions as “persons” under the act. About the same time, the Gramm-Leach-Bliley act gave permission to banks to borrow more for both necessary and other reasons – that is, to increase the share of non-deposit liabilities on their balance sheets. So they set up this whole interconnection game in which they borrow from one another and, in the process, are creating liquidity by monetizing debt. Of course, its all on paper – its all a pyramid – and in the end it can collapse and did.

The solution is to limit the funding that goes into prop trading as well as banning the trading itself for those institutions that have access to the Fed. And if that were done – if section 610 became law – even the investment banks wouldn’t be able to engage in excessive proprietary trading because they couldn’t get the funding to do so.

A lot of this sounds like a problem of the way we handled the bailouts where we converted a lot of firms that were not banks, not funded out of core deposits, into bank holding companies, and giving them access to fed window and also fdic insurance I suppose, but the fed window introduced new problems now that you have a lot of these prop desks supercharged. Is that accurate?

I agree and I think the Merkley-Levin amendment is a very productive step in the right direction because it requires the ban in the statute rather than as a result of rule-making by regulators. It also adds a provision that deals with material conflicts of interest by prohibiting securities originators from engaging in transactions that would undermine the value, safety or performance of the securities they sell to clients. That is another very useful part of that amendment.

Can you talk a little about that conflict of interest as well?

It’s come to be called the Goldman provision – a response to the revelations about Goldman Sachs and Paulson that led to the SEC’s suit. But when Goldman and other investment banks defend themselves by saying “we’re only hedging”, you have to wonder if underlying all this is the simple fact that derivatives sold over the counter by these dealers aren’t structured in ways that necessarily erode fiduciary responsibility. It’s a zero sum game in which the person who sells the derivative is in effect betting against the position of the buyer. It seems to me that we have lost the concept of fiduciary responsibility in this corner of the financial sector, something that is quite important in terms of maintaining confidence in the system. If the legislation requires derivatives to be sold on exchanges where the counterparty is the exchange itself, you eliminate a lot of the conflict of interest, the temptation to engage in conflicts of interest, that has been so prevalent in the OTC market.

Yeah one thing I notice about this bill is it has a lot of legal and structural fixes that are important but it doesn’t do much to change the culture of Wall Street which is obviously a big problem and not easily done through legislation. But returning to some of the legal obligations, with that comes a system of norms that might be helpful for the 21st century, so if you’re not promoted or given a big bonus for ripping the face off a client, that trickles down in to the normal types of relationships you have with the clients. I think that could be helpful in ways we don’t imagine yet.

Yes, yes it could.