The Volcker Rule and the Saga of State Street Bank

Cambridge Winter Center’s Raj Date has a new paper out: Test Case on the Charles: State Street and the Volcker Rule.

In order to get a sense of why the Volcker Rule would be important, he walks his audience through the story of State Street bank, the 15th largest bank that had a nice, stable boring business model and decided to jump into the deep end of finance, necessitating a bailout at the end. Here’s Raj:

At first glance, State Street would seem an unlikely test case for the Volcker Rule. It is, after all, only the 19th largest bank holding company, with roughly $150 billion in assets. But like Bank of New York Mellon, and to a lesser extent Northern Trust, State Street has a systemic importance that is vastly disproportionate to its balance sheet size. State Street serves as “custodian” for more than $19 trillion in assets…To most observers, custody is a dreadfully dull affair: a scale-intensive, IT dependent processing business in which low-cost operations are key and pricing is measured in single-digit basis points. Although its revenues are market-sensitive, it is typically viewed as a lower-risk banking business, given that it is not prone to large credit- or interest rate-risk shocks.

Raj has many graphs that tell the story about why it is a good idea to silo out the high risk from the necessary, core functioning of the banking sector. I want to focus on three. Here’s what boring banking looks like:

Click through on all three for a bigger graph with explanation. There it goes, making single basis point income off acting as a custodian for trillions of dollars of assets. This custody business is profitable, safe, and boring. So where do they dive into the deep end? Here’s what exciting banking looks like:

Off-balance sheets conduits took on credit and liquidity risk by funding medium and long term asset-backed securities through short-term commercial paper. This business model eventually imploded. The stock took a 60% hit in a single day in January 2009 as the market realized these off-balance sheet conduits would need to be consolidated. It did not face a liquidity run thanks to FDIC, the Federal Reserve, and a post “stress test” equity raise. Rather than have this key mechanism of how financial markets work not be able to turn on their lights, taxpayers rushed in with bailout money. This graph walks through the bailout mechanism:

This is why the core of the financial sector needs to be protected. The temptation to take a boring business line, like this custodial mechanism for record-keeping among equities and bonds, or the boring insurance lines of AIG, and stick a giant hedge fund or shadow bank on top of it is going to be too much for businesses. And when the temptation is too much for businesses, it’s going to be too much for regulators to make the call. Hence why we want to write these rules into the bill, and failing that, as close to the bill as reasonably possible.

Raj and I had some follow-up conversations about the Volcker Rule and State Street, and here is what he said:

Hedge funds fail all the time; P.E. funds do too. That’s sad, I’m sure, for the principals, and the investors, but that’s just life in the big city. But that doesn’t mean you should deliberately create a structure in which their failure brings the system down with them, or a structure that allows them to siphon value from a bank charter that exists for a decidedly different reason. Frankly, it is the separation of these vehicles — all of which serve legitimate purposes — from the banking system that enables us to ‘just let them them fail.’

And it’s hard to imagine what failure (aside from the failure of a major sovereign, or of quasi-sovereigns like the GSEs) would be more disruptive than that of a major custody bank. These firms — State Street, Bank of New York, JP Morgan — are a big part of the central nervous system of the markets. If you thought Lehman was bad — well, my advice in that case would be: buckle up, you’re in for the scariest ride of your life.

Two things to note: the “siphoning of value from a bank charter” is a serious problem now that many of the biggest players were given bank charters as a result of the bailouts. And the other is that the “fail all the time” part of the equation for hedge funds and other investment vehicles is incredibly important. Social insurance in the form of Federal Reserve access isn’t needed for this; this is why we have unemployment insurance. And I’d be more than happy to give 99 weeks of that to the employees of a failed Too Big To Fail firm if we can actually resolve it in the next crisis. The Volcker Rule gets us closer to that goal.