A funny thing happened in June of 2007. Back when times were better, Bear Sterns had previously created two hedge funds, one in 2004 and one in August of 2006, named “Bear Stearns High-Grade Structured Credit Fund” and “Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund.”
As the New York Times explained it in June 2007, “…41 months of positive returns of about 1 percent to 1.5 percent a month. But investors were clamoring for even higher yields, which would require more aggressive bets on riskier mortgage-related securities and significantly higher levels of borrowed money, or leverage, to bolster returns.”
So Bear Sterns put up $40 million dollars of its own money into these two firms between 2004 and 2006, and in June 2007, Bear had to bail out these two funds with a line of credit worth $3.2 billion dollars. A $40 million dollar upfront bet sponsoring a hedge fund ended up putting them on the hook for billions of dollars in losses. They got a nice trickle of returns for loading up on the tail risk, a great strategy that works until it doesn’t.
And that’s fine that they did that. The question is do we need banking firms that have access to the discount window, banking firms that receive FDIC insurance, the commercial banking firms that handle deposits and form the backbone of our lending and payments systems, to be making these bets? Should firms that are protected under the safety umbrella of commercial banking be making proprietary bets, bets that can go lopsided quickly and with devastating losses?
The Volcker Rule works under the assumption that they shouldn’t. That these activities are great for hedge funds to go gamble with, but if you are a bank you need to be regulated like a bank, and part of that involves not running hedge funds that puts depositors and taxpayers at risk.
More than the Dodd Bill
Given that section 619 of the Dodd Bill makes provisions for Volcker Rule, why is the Merkley-Levin Amendment (SA 3931) necessary?
Section 619 right involves the Council of regulators, which includes (and will likely be overly influenced by) the Federal Reserve, Treasury and the OCC, would come together and do a study, and then decide what if any restrictions they want to impose. The bank regulators would then go about implementing them.
The problem is that the Council, the way the Dodd Bill is written, has very broad authority to determine what type of regulations they want to impose and what kinds of exemptions they want to give. It allows the Council can rewrite the rules as they see fit. The Section 619 language also doesn’t have conflict-of-interest language at all.
A Floor, Not a Ceiling
Economics of Contempt has a critique that says that this amendment tries too hard, and that in defining what proprietary trading is it creates new loopholes that industry can drive through, and that regulators on the ground will have better knowledge of the specific ins and outs of what does and does not constitute proprietary trading. As EoC concludes: “People often ask why I say that complicated financial regulations can’t be written at the statutory level. The reason, sorry to say — which Merkley-Levin demonstrates quite well — is that Congress sucks at writing complicated financial regulations.”
The disagreement is over what constitutes a “permitted activity”, what is allowed, and whether or not it is so broad regulators on the ground would be able to do better. I think Merkley-Levin is way ahead of this critique, and what EoC doesn’t mention is that the bill provides for this. In case they excluded too much from permitted activities at the statutory level, regulators can add some provided it meets a certain threshold (p. 10):
‘‘(d) PERMITTED ACTIVITIES…(I) Such other activity as the appropriate Federal banking agencies, in consultation with the Securities and Exchange Commission and the Commodity Futures Trading Commission, jointly determine through regulation, as provided for in subsection (c), would promote and protect the safety and soundness of the banking entity or nonbank financial company and the financial stability of the United States.
If there are activities that could be justified in promoting safety and soundness, regulators can include them into the bucket of permitted activities. Note that this is a fairly high bar to hurdle, so regulators have to make a fairly good excuse to go for it. Now let’s say that an element in the bucket of permitted activities is good in theory, but regulators want to be able to beef up requirements based on that element. In the amendment, regulators can increase their supervision of a permitted activity (p. 11-12):
(3) CAPITAL AND QUANTITATIVE LIMITATIONS.—The Board, in consultation with the Securities and Exchange Commission and the Commodity Futures Trading Commission, shall adopt rules imposing additional capital requirements and quanitative limitations regarding the activities permitted under this section if the Board determines that additional capital and quantitative limitations are appropriate to protect the safety and soundness of the banking entities and nonbank financial companies engaged in such activities.
Now that’s in one direction. What if EoC’s critique is correct, and that financial firms will be able to abuse a permitted activity in a manner intended to evade the requirements of the amendment? Well, the amendment allows the regulators to go after that:
(2) TERMINATION OF ACTIVITIES OR INVESTMENT.—Notwithstanding any other provision of law, whenever an appropriate Federal banking agency or the Securities and Exchange Commission or Commodity Futures Trading Commission, as appropriate, has reasonable cause to believe that a banking entity or nonbank financial company under the respective agency’s jurisdiction has made an investment or engaged in an activity in a manner that is intended to evade the requirements of this section (including through an abuse of any permitted activity), the appropriate Federal banking agency or the Securities and Exchange Commission or Commodity Futures Trading Commission, as appropriate, shall order, after due notice and opportunity for hearing, the banking entity or nonbank financial company to terminate the activity and, as relevant, dispose of the investment; provided that nothing in this subparagraph shall be construed to limit the inherent authority of any Federal agency or state regulatory authority to further restrict any investments or activities under otherwise applicable provisions of law.
Isn’t that clever? “Regulators, you have to follow these rules, but if you want to make them stricter by all means go ahead.”
Again, it’s a floor, not a ceiling. This is a good solution for how to use the best that regulators can bring to the table without assuming they are perfect. I brought it up when talking about state consumer pre-emption. If you have two potential regulations, the smartest game theory move is to follow the strategy where you always pick the stricter one. That’s what having a firm baseline written down, and then regulators with the ability to increase it as they see fit.
UPDATE: Yglesias posted a response to EoC’s critique sent from Merkley’s office, that is also worth checking out as you make up your mind on this matter.
UPDATE 2: Zach Carter at Huffington Post also responds to EoC’s argument.