Proprietary Trading is a Bigger Deal than Most Bankers and Pundits Claim
President Obama’s endorsement of the “Volcker Rule” – a set of proposals designed to reduce public financial support for risky proprietary trading and hedge/private equity fund ownership by commercial banks and bank holding companies - has elicited an intense chorus of responses from bankers, economists and policy makers. The most vehement and uniform have come from the bankers themselves, and have been echoed uncritically by much of the business press and many Republican politicians. These responses have been twofold. First, proprietary trading had little to do with the current financial crisis and therefore restricting it would do little to prevent a replay; and second, proprietary trading provides a very small percentage of bank revenues and therefore is not very important.
The implication of these two points is that it is not really worth the political battle to restrict proprietary trading because it is small and unimportant.
A third set of arguments has been made by many bloggers, economists and some financial analysts: namely, that Volcker’s very narrow limits would make it easy for bankers to evade the restrictions and, moreover, would allow investment banks and others in the shadow financial world to undertake many risky and dangerous activities that could crash the system and require tax payer bail-outs. This implies that the Volcker Rule would have to be beefed up considerably as well as broadened to include investment banks, hedge funds and other corners of the financial world, in order to truly reduce the risk in the system to acceptable levels and to significantly reduce the likelihood of the need for future massive tax payer bail-outs.
In this note we argue that the conventional banker wisdom is incorrect. First, proprietary trading, properly defined and contextualized, had a great deal to do with the crisis. We produce several types of evidence to suggest that proprietary investments and trading were large and had a significant impact on the crisis. For example, we cite evidence that by mid-April of 2008 large banks had lost roughly $230 billion dollars on their super-senior CDO proprietary holdings, which regulators and other interested parties believed were simply inventories of assets held to facilitate client trading. If one makes the crude assumption that this represents a loss of approximately one-third of their value, then banks were holding three quarters of a trillion dollars of these highly risky assets. Clearly, proprietary trading, properly defined, was a major cause of the recent crisis. Second, we present rough estimates that suggest that this type of trading and investment was much more important for the bottom line of major banks than has been reported by banks and bank analysts and, subsequently, repeated in the press.
At the same time, the critics are certainly correct that to be truly helpful the Volcker rule has to be significantly strengthened and broadened, specifically to large investment banks and the shadow banking system.