One of the many provisions of the Dodd-Frank financial reform legislation was a section intended to prohibit proprietary securities trading by commercial banks, e.g. that wasn't at the behest of clients. It was strongly advocated by former Federal Reserve Chairman Paul Volcker.
"Don't gamble with depositors' money!" was the stern injunction. But what is the difference between gambling and taking risks? Card-players, most conspicuously blackjack players, can be extremely careful in calculating the odds at any given point and disciplined in how they play. Are they "managing risk" or are they "gambling"?
Similarly, when bankers make loans to individuals and companies they expect to incur losses. But if they are disciplined in their lending, their good loans provide earnings that offset losses on the bad loans and still leave something for the shareholders.
FX 101. Providing customers with the ability to buy and sell foreign exchange, government securities, or interest rate swaps is important function of large banks. But banks cannot undertake large transactions in these markets without incurring a variety of risks.
Let me, as a former foreign exchange system manager, give a relevant example. If General Motors contacts Citibank and asks the foreign exchange desk for a price on $300 million New Zealand dollars for delivery exactly six months from now, it does not tell the bank whether it wants to buy or sell $NZ.
If Citibank wants to keep General Motors as a foreign exchange customer, it has to quote realistically on both the buy and sell side, since the traders at General Motors monitor second-by-second many of the same computer screens as the traders at Citibank.This forces the bank to quote a very narrow "spread" between its buying and selling prices.
But, assuming GM accepts a quote from Citibank, the bank will end up with a $300 million risk position if it does not already have another customer at the same time whose deal would fully offset the new transaction. (Indeed, it might end up with an even larger risk position if it had been already exposed from earlier deals.) Saddled with increased risk, the trading desk must now decide how and how quickly to reduce its exposure (within five minutes? end of day? end of week?).
Collateral Damage. The same trading realities rule the markets in other financial instruments.This is why a number of foreign governments have expressed alarm at the intended regulations: they are concerned that the U.S. banking institutions which have "made markets" (provided "liquidity") for buyers and sellers of their sovereign debt will reduce their market-making activity. That would result in wider "spreads" and increase the cost of issuing new sovereign debt. This fear is substantiated by the fact that trading in U.S. government securities would be exempt from the Volcker rule.
Totally "naked" speculative trading, such as recently brought down MF Global Holdings, is easy to spot. But trying to divine when, in the minds of the trader, the lines between customer-related market-making, hedging and outright speculation have been crossed is an impossible task - even with the 300 pages of regulation and explanation that attempts to implement the Volcker Rule.
The most comprehensive and substantive criticism of the proposed rule can be found in the January 18 Congressional testimony of Brookings fellow Douglas Elliott. He makes a strong case for repealing the rule or, at the very least,
". . . for Congress to send a clear signal that regulators are to implement the rule in a modest fashion that focuses on stopping only those activities that very clearly violate the Volcker Rule without halting activities where the intent of the transactions is unclear."
Even Paul Volcker sounds contrite about the proposed regulation, telling Charlie Rose recently that "Oh, I think it's OK . . . the regulation itself is only 35 pages."
Hopefully regulators and Congress are paying attention to the warnings from every direction - and recalling the words of Reinhold Niebuhr: "We mean well and do ill and justify our ill-doing by our well-meaning." But Chairman Volcker may be in for another lesson in the law of unintended consequences.
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