This article was sent to me by a friend, Rob:
So, I find the debate about the Volcker rule to be interesting for a bunch of reasons.
1) I think the limits on bank size are VERY dumb and actually terrible for the system. http://tfideas.blogspot.com/2010/01/prop-trading.html. I have updated my thoughts on the prop trading aspect as I've thought about them, so see below.
2) The limits on prop trading are mixed. On the one hand, there aren't significant synergies and it may make bank incentives more inline with treating customers well. It does reduce bank diversification, so that you probably see more frequent credit issues when commercial lending is in trouble but prop assets aren't, or vice versa, but it shrinks the size of those crises. So it's a tradeoff of frequency for severity, with perhaps a little bit of incentive push. That's a good thing.
The interesting part is going to be what it means for liquidity. I think day trading is worthless for liquidity (I'm not saying you can't do it - I know you work with it - just that it has no social value. Neither does Coca-Cola, but so that goes), and restricting HFT and UHFT, in particular, could actually have some very beneficial societal effects in terms of slowing down collapses to give people time to react, and also just leaching less money away from long term investors (in the form of arbitraging their lack of attention to penny-level detail), giving people more incentive to invest. These are the kind of prop bets that Goldman, etc, say they make.
However, if you define some of the stuff banks use on their balance sheet as prop trading, it significantly alters the demand for various credit flows. It's a brilliant and kind of nefarious way for the government to finance a massive deficit to say that banks can only use treasuries, but it comes at the expense of small business loans, mortgage loans, etc, that are important to the functioning of the economy. Remember that the only reason these banks could use that kind of security on their balance sheets was because they were backed by Fannie, Freddie, Ginnie, Sallie and the other GSEs, and thus counted as government loans. US government bonds carry risk, too (though I doubt any default would come in the form of explicit default, but instead on inflation, which doesn't crater banks).
So the Volcker rule is a backchannel way of facilitating a one-shot expansion of the deficit, while decreasing the private sector role of financing and generally just making credit less available, leading to slower overall macro growth. In other words, the Volcker state makes us look like Europe, which isn't a good thing, if it's applied to the longer term bonds that the banks own.
Thus, neither portion of the Volcker rule is actually that appealing as Volcker envisioned it. Volcker's considered a legend because he had the courage to raise interest rates to lower inflation - he's conservative in the "not aggressive" sense and doesn't seem to value macro growth that highly, which is why it was possible for him to crush inflation. I'd argue that's not a prudent approach here.
There are people out there more qualified than me, but it seems to me that the proper response to this financial crisis is:
a) cut down on some bad industry practices - flash trading, probably dark pools, day trading/prop trading in its strictest sense by banks, and HFT and UHFT with some sort of "turnover tax" where you're taxed for turnover in excess of 400% of your highest account value for the year (400% chosen bc earnings are reported quarterly) - outlined here http://tfideas.blogspot.com/2010/01/how-to-deal-with-high-frequency-trading.html
b) focus on "too interconnected to fail" instead of "too big to fail" - create exchanges for as much as you can (doesn't eliminate interconnectedness but definitely reduces the size of bailouts when they do need to happen), create some sort of counterparty guidelines for banks who lend to each other and cancel derivatives by reselling them to each other, etc.
c) subject anyone who trades in securities that are allowed on bank balance sheets to leverage or capital requirements - so hedge funds who trade in things that can sink banks can't sink banks as easily, etc.
d) it'd be good to see the uptick rule in place for financial companies, at least - I know shorting is important but when your stock price affects your capitalization and your capitalization affects your survival, there needs to be something in place to prevent abuses.
e) Instead of a bank tax or tobin tax, create some sort of accelerating bailout tax (in the future this could be done with interest rates, but retrospectively it has to be a tax), where companies pay more and more for the bailout money they took the longer they hold onto it. Companies that really, really need the bailouts are going to pay for them, whereas companies just caught up in a crisis dont really get punished for what was not bad behavior. It also delays bank bankruptcies to a point where the system is a little more robust, but still makes them possible, mitigating moral hazard. I won't go into huge detail but i outline it here: http://tfideas.blogspot.com/2010/01/instead-of-bank-tax-why-not.html
EDIT: More on why defining "prop trading" as anything a bank holds for a long time is a problem: it mitigates banks' ability to offset some very, very uncertain credit risks. I've mentioned this before here, in my post about financial innovation:
http://tfideas.blogspot.com/2010/02/financial-innovation.html
and there is a very nice expansion on this by an Australian Hedge Fund manager in his blog:
http://brontecapital.blogspot.com/2010/01/what-is-proprietary-trading.html
"Imagine a suburban bank which takes deposits and makes mortgages.
The deposits are primarily at-call and pay a floating interest rate. Legally they bank has overnight money – and if interest rates rose then the next day the customers could (in theory) all withdraw their money and/or ask for a higher interest rate. The bank does not really know what interest rates it will be paying next week let alone in three years.
In reality the customers of the bank are sticky. There is no way that everyone will pull their money in response to a short term rate rise. The funding of the bank is of uncertain duration.
On the asset side the bank lends on fixed rate but refinanceable mortgages. The bank really has no idea how long the mortgages will last. If rates go down they might all be refinanced tomorrow. People might just sell all their houses and repay their mortgages. In reality however the customer are likely to be somewhat sticky. On the asset side the bank has uncertain duration.
This plain vanilla bank has interest rate risk. If rates rise their funding costs will rise relative to their asset yield. If rates fall their assets will refinance. Their funding cost might also fall – but at the moment the funding cost seems pinned by the zero-bound.
Some hedging of interest rate risk here seems entirely sensible. Banks (and more often S&Ls) have failed in the past because they failed to hedge this sort of interest rate risk. However as both the assets and liabilities are of uncertain duration there is no way of knowing just how much hedging is required. There is a choice here – it is a proprietary choice (in that the bank will trade off hedging costs against profits). And there is no easy way to legislate that choice away."
Edit 2:
one response to the Time article above (not this blog post), by a very, very intelligent friend of mine, who also happens to not be a banker or economist (this should highlight some of the challenges that face intelligent financial reform - even very smart people have trouble with the banking system because our banking system, inherently, is very complex, and I'd be willing to bet you that the writer of this is much smarter than most Congresspeople):
"1) I think the companies on question, on the whole profited from the activities ~ however, since the profits were not put aside for the potential rainy days/year to follow, when the downside indeed materialized, some of these institutions were badly hurt. Instead of giving out 70% of profit as bonuses, the companies could have kept them or distributed to shareholders,who might be willing to tolerate the risk of the downside. Although indeed the losses from propriety trading "did in" these banks, it was because there was no cash cushion ~ which was plundered by management, who did not have to worry about any downside as much
2) One argument in the Time article was: ""If companies can't sell stock or bonds as easily as investors would like to buy them, the cost of capital will go up," says James Ellman, president of the money-management firm Seacliff Capital. "That hurts companies' ability to expand, buy equipment and create jobs. GDP grows slower." Well, this is actually precisely what one would *hope* would happen: If the cost of capital is too high to build those new condos *maybe* you shouldn't be building them. If your GDP is growing too fast due to too much liquidity, eventually you'll crash ~ so slower GDP growth is necessary to avoid harsh corrections. "
My response:
"on 1)
i'm not sure you can look at bonuses as an offset for capital structure, because salary is competitive. If they cut salary, talented people go elsewhere and the profits never materialize. It's the result of a system in which a) the demand for good bankers is very high, and the return to having a good banker is way, way above any conceivable cost, b) the supply of good bankers is very low given banking demand, because banking is hard, and c) it's not always the easiest to tell who is and who isn't a good banker because even the very best fail and even the very worst get lucky. This is a recipe for a "keeping up with the Joneses" salary system where banks pay very high salaries to anyone who looks like they could have talent, because the upside if they're right is so unbelievably high and the downside if they're wrong is so much smaller (which still applies despite the financial crisis, btw).
In other words, banking bonuses weren't the cause of the crisis (in fact, BANKING, in general, wasn't really the cause of the crisis, just the most obvious and stupid piece of a complex system to get crushed). Going after the level of banker bonuses will a) not solve any problems at all even if you were successful, and b) won't be successful because finance is very, very mobile and countries have an incentive to compete for financial infrastructure.
You could have "saved up for a rainy day" by lending at higher interest rates, or lending less. That's a competitively feasible way of saving up for a rainy day... but generally speaking, that's not an issue of greed, it's one of incompetence and mismeasurement, which is why it's such a damn hard problem to fix.
on 2)
cost of capital isn't quite what you're referring to.
what Ellman means is that creating friction or reducing the depth of markets (making it hard to sell stocks or bonds, or reducing the number of them available for sale) will mean people will have to pay more for the exact same benefit. The goal is, and should always be, to have the cost of capital stay low.
The situation you're referring to with the condos isn't about the cost of capital, it's about risk management on the return side.
Very generally speaking, the "economic value added" of a project is equal to its return on invested capital minus its weighted average cost of capital.
What this means is that the economic value of a project is the amount you can make on each dollar you invest minus the cost of obtaining each dollar you invest. Most fundamentally, it's revenues minus costs.
Now, if you take something that is entirely debt funded, then your cost of capital is pretty set - it's the interest you pay on your debt. The revenue you can take in, of course, is far more uncertain, and you have to make projections.
What matters to "not building things in the first place" is that spread between revenue and costs, not the level of costs - if you have a high cost of capital, fewer things get built, but the risk of those things defaulting is determined on the revenue side and thus is entirely independent of the cost of capital. So the problem with a condo that defaults is that people didn't understand the potential revenue distribution, and took projects whose potential spread was too small. Raising the cost of capital would make it a smaller problem because less overall (real) economic activity can take place (it's very hard to have a problem if you have sackfuls of cash with nothing to do with them) but that's not really an effective way to deal with the problem. the issue, instead, should be a) estimating that revenue side better so that you can learn more about the profit margin and b) capital structure controls that ensure people don't take margins that are too small and lets them absorb any mistakes they make without failure.
That isn't done effectively by raising the cost of capital."
EDIT: More on why defining "prop trading" as anything a bank holds for a long time is a problem: it mitigates banks' ability to offset some very, very uncertain credit risks. I've mentioned this before here, in my post about financial innovation:
http://tfideas.blogspot.com/2010/02/financial-innovation.html
and there is a very nice expansion on this by an Australian Hedge Fund manager in his blog:
http://brontecapital.blogspot.com/2010/01/what-is-proprietary-trading.html
"Imagine a suburban bank which takes deposits and makes mortgages.
The deposits are primarily at-call and pay a floating interest rate. Legally they bank has overnight money – and if interest rates rose then the next day the customers could (in theory) all withdraw their money and/or ask for a higher interest rate. The bank does not really know what interest rates it will be paying next week let alone in three years.
In reality the customers of the bank are sticky. There is no way that everyone will pull their money in response to a short term rate rise. The funding of the bank is of uncertain duration.
On the asset side the bank lends on fixed rate but refinanceable mortgages. The bank really has no idea how long the mortgages will last. If rates go down they might all be refinanced tomorrow. People might just sell all their houses and repay their mortgages. In reality however the customer are likely to be somewhat sticky. On the asset side the bank has uncertain duration.
This plain vanilla bank has interest rate risk. If rates rise their funding costs will rise relative to their asset yield. If rates fall their assets will refinance. Their funding cost might also fall – but at the moment the funding cost seems pinned by the zero-bound.
Some hedging of interest rate risk here seems entirely sensible. Banks (and more often S&Ls) have failed in the past because they failed to hedge this sort of interest rate risk. However as both the assets and liabilities are of uncertain duration there is no way of knowing just how much hedging is required. There is a choice here – it is a proprietary choice (in that the bank will trade off hedging costs against profits). And there is no easy way to legislate that choice away."
Edit 2:
one response to the Time article above (not this blog post), by a very, very intelligent friend of mine, who also happens to not be a banker or economist (this should highlight some of the challenges that face intelligent financial reform - even very smart people have trouble with the banking system because our banking system, inherently, is very complex, and I'd be willing to bet you that the writer of this is much smarter than most Congresspeople):
"1) I think the companies on question, on the whole profited from the activities ~ however, since the profits were not put aside for the potential rainy days/year to follow, when the downside indeed materialized, some of these institutions were badly hurt. Instead of giving out 70% of profit as bonuses, the companies could have kept them or distributed to shareholders,who might be willing to tolerate the risk of the downside. Although indeed the losses from propriety trading "did in" these banks, it was because there was no cash cushion ~ which was plundered by management, who did not have to worry about any downside as much
2) One argument in the Time article was: ""If companies can't sell stock or bonds as easily as investors would like to buy them, the cost of capital will go up," says James Ellman, president of the money-management firm Seacliff Capital. "That hurts companies' ability to expand, buy equipment and create jobs. GDP grows slower." Well, this is actually precisely what one would *hope* would happen: If the cost of capital is too high to build those new condos *maybe* you shouldn't be building them. If your GDP is growing too fast due to too much liquidity, eventually you'll crash ~ so slower GDP growth is necessary to avoid harsh corrections. "
My response:
"on 1)
i'm not sure you can look at bonuses as an offset for capital structure, because salary is competitive. If they cut salary, talented people go elsewhere and the profits never materialize. It's the result of a system in which a) the demand for good bankers is very high, and the return to having a good banker is way, way above any conceivable cost, b) the supply of good bankers is very low given banking demand, because banking is hard, and c) it's not always the easiest to tell who is and who isn't a good banker because even the very best fail and even the very worst get lucky. This is a recipe for a "keeping up with the Joneses" salary system where banks pay very high salaries to anyone who looks like they could have talent, because the upside if they're right is so unbelievably high and the downside if they're wrong is so much smaller (which still applies despite the financial crisis, btw).
In other words, banking bonuses weren't the cause of the crisis (in fact, BANKING, in general, wasn't really the cause of the crisis, just the most obvious and stupid piece of a complex system to get crushed). Going after the level of banker bonuses will a) not solve any problems at all even if you were successful, and b) won't be successful because finance is very, very mobile and countries have an incentive to compete for financial infrastructure.
You could have "saved up for a rainy day" by lending at higher interest rates, or lending less. That's a competitively feasible way of saving up for a rainy day... but generally speaking, that's not an issue of greed, it's one of incompetence and mismeasurement, which is why it's such a damn hard problem to fix.
on 2)
cost of capital isn't quite what you're referring to.
what Ellman means is that creating friction or reducing the depth of markets (making it hard to sell stocks or bonds, or reducing the number of them available for sale) will mean people will have to pay more for the exact same benefit. The goal is, and should always be, to have the cost of capital stay low.
The situation you're referring to with the condos isn't about the cost of capital, it's about risk management on the return side.
Very generally speaking, the "economic value added" of a project is equal to its return on invested capital minus its weighted average cost of capital.
What this means is that the economic value of a project is the amount you can make on each dollar you invest minus the cost of obtaining each dollar you invest. Most fundamentally, it's revenues minus costs.
Now, if you take something that is entirely debt funded, then your cost of capital is pretty set - it's the interest you pay on your debt. The revenue you can take in, of course, is far more uncertain, and you have to make projections.
What matters to "not building things in the first place" is that spread between revenue and costs, not the level of costs - if you have a high cost of capital, fewer things get built, but the risk of those things defaulting is determined on the revenue side and thus is entirely independent of the cost of capital. So the problem with a condo that defaults is that people didn't understand the potential revenue distribution, and took projects whose potential spread was too small. Raising the cost of capital would make it a smaller problem because less overall (real) economic activity can take place (it's very hard to have a problem if you have sackfuls of cash with nothing to do with them) but that's not really an effective way to deal with the problem. the issue, instead, should be a) estimating that revenue side better so that you can learn more about the profit margin and b) capital structure controls that ensure people don't take margins that are too small and lets them absorb any mistakes they make without failure.
That isn't done effectively by raising the cost of capital."
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