Your Chance to Fix Wall Street

The following is our response to the Financial Stability Oversight Council's request for public comments on implementation of the Volcker rule.

Trading can be dangerous, even when you're confident in your abilities (especially when you're confident, actually). Just ask Wall Street, which by April 2008 had lost some $230 billion, mostly on the safest portions of its CDO holdings, according to the Financial Times.

It wasn't always this way.

In response to the mixing of commercial and investment banking leading up to the 1929 financial collapse and Great Depression, Congress passed the Glass-Steagall Act, separating trading from traditional banking. If you wanted to be a bank, taking deposits and making loans, you were given access to Federal Reserve funding and Federal Deposit Insurance Corp. backing for deposit holders -- a special guarantee that safeguarded the vital economic lubricant of commercial banking. Everything else, from trading to investment banking, had to be segregated, and took place primarily in privately held partnerships that remained intimately vigilant of the risks they took and didn't put either taxpayers or the aggregate financial system in the line of fire when things turned south.

Since the 1960s, that seemingly unassailable rationality came under attack by the industry, culminating in the repeal of key sections of Glass-Steagall in 1999. With the stroke of a pen, banks reverted to the "supermarket" banking structure, where flagrant risk-taking could take place under the roof of a taxpayer-backed commercial bank. If you've heard of Citigroup (NYSE: C  ) , you know how that story ends.

After the financial crisis of 2008, reason attempted a comeback. Congress passed a financial reform bill that attempts to restore the separation between trading and commercial banking with provisions known collectively as the Volcker rule, named after former Fed Chairman Paul Volcker. The key insight is that, while commercial banking is necessary for connecting investors and borrowers, allowing commercial banks to trade with their own capital risks the entire system, and simply doesn't deserve a public guarantee.

Betting on a long shot
There are two types of trading. One is purely proprietary, where banks use their own money to place bets. The other is market making, where banks buy securities from one investor and sell them to another, acting as a broker. Both have been big money makers for banks such as Goldman Sachs (NYSE: GS  ) and JPMorgan Chase (NYSE: JPM  ) in recent years.

The Volcker rule bans proprietary trading but includes an exemption for market-making trades under limited conditions.

That's where the mischief comes in.

The Volcker rule is fuzzy regarding what constitutes pure proprietary trading versus market making. There's no clear definition. And as a general rule of regulation, remember this: When there's no clear definition, there may as well be no definition at all.

In this case, it isn't complicated for banks to simply rebrand their proprietary trading as market making, rendering the Volcker rule irrelevant. The road map is easy: A bank buys a security, claiming the purchase was done for a client who wanted to sell (classic market making). It then holds that security, refusing to resell at the going market bid price, instead holding the securities as market-making "inventory." If those securities gain value, the bank sells and collects a nice bonus. If the securities start exploding en masse, the financial system and taxpayers shoulder most of the risk.

From a legal standpoint, the bank is acting as a market maker. But it's really taking proprietary-trading positions. Nothing changes.

Democratic Sens. Jeff Merkley (Ore.) and Carl Levin (Mich.), co-sponsors of the Volcker rule, explain further:

Because every trade has a counterparty, if market-making were defined to be any time a financial firm takes a position opposite to a counterparty, then every principal trade would be market-making. While some industry participants may espouse this view, such an interpretation would render the Dodd-Frank protections meaningless, and is plainly not what Congress intended.

Red flags a-blazin'
There are a few tell-tale signs of obvious proprietary trading:

  • Profits and losses are generated by changes in value, rather than bid/ask spreads.
  • Trades tend to be longer term in nature.
  • Trading results may vary considerably.

But all of these distinctions can be gamed -- proprietary trades can be executed as bid/asks, traders can churn positions to reduce their duration, and many proprietary strategies produce generally smooth results, but have a tendency to occasionally explode. There's still substantial room for gamesmanship.

To minimize this risk, regulators will need to have access to trade-by-trade data and closely monitor firms with these warning signs in mind to prevent evasion of the spirit of the rule.

This may seem a daunting task -- and it is. Frankly, we're glad we're not the ones who have to write and enforce these rules. As Volcker himself told the Federal Reserve Bank of Chicago on Thursday, "Relying on judgment all the time makes for a very heavy burden whether you are regulating an individual institution or whether you are regulating the whole market."

Here are a few things that could make your life a little easier
If regulators fully implement the limitations on market-making exemptions under Section 619(2), which prohibit trading that may subject banks to material risk, trading at banks will decline substantially, making monitoring and enforcement of prohibitions against proprietary trading much easier.

Regulators should monitor not just trades, but trading inventory, like hawks. Treat inventory like cars picking people up from airports: no parking, no waiting. Just keep moving. If you misuse the pickup/drop-off spot, you get towed at punitive cost. If you park with a nuclear bomb, there are more serious consequences.

Regulators should also place an upper limit on the total amount of allowable trading banks are allowed to engage in, as authorized under Section 619(3). This limit must be narrow enough to prevent a firm from taking on material exposure to high-risk trading strategies or threaten the safety and soundness of the bank. Because overconcentration fails both tests, an appropriate way to think about limits to market making is to consider the amount of capital a bank can stand to be without during a financial crisis. Since everything becomes correlated during financial crises and hedges may fail, regulators should consider limiting not only net exposures, but also total unhedged exposures or even total exposures for trading to a certain percentage of tier 1 capital.

Just get the job done
Congress and the American people's intentions are clear. Nowhere does the law ask regulators to weigh the merits of safety and stability with trading profits.

And if the upshot of limiting trading at banks is more lending to the real economy, even better. That's what banks are supposed to be doing anyway.

If you want to make your opinion heard, the council is accepting comments on the Volcker rule until 11:59 p.m. tonight. Follow this link for instructions on how to post your comment.

And if you'd like us to keep you posted on the Volcker rule's progress and other issues related to financial reform and shareholder rights, just send a blank email to imoscovitz@fool.com.

Neither Ilan Moscovitz nor Morgan Housel own shares of any company mentioned. The Motley Fool owns shares of JPMorgan. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool is investors writing for investors and has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (36)

Comments from our Foolish Readers

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  • Report this Comment On November 05, 2010, at 4:47 PM, mikeness30 wrote:

    While all of this is true, this is all simply symantics. You want to control risk amongst banks within their proprietary books it is rather simple: let them fail when they take on too much risk. You might be surprised how much differently they act, they did for a long period of time. You can not have the implicit understanding of too big too fail and allow banks to risk their captial. The other thing you would really need to do is clean up and simplify quarterly/yearly balance sheet and income statments from banks. No more off-off-off b/s shenigans.

  • Report this Comment On November 05, 2010, at 6:54 PM, xetn wrote:

    Amen mikeness30. We already have way too much regulation and it is never enough. Regulations really end up protecting some at the expense of others and ultimately add huge costs to businesses who then pass them on to the consumers. In fact, regulation is nothing more than a hidden tax.

    And they are so ineffective that even when various attempts to inform the regulators about the ponzi scheme of Maddoff, they did nothing.

    The best regulation is "let the buyer beware" and vote with your money. Trying to protect everyone from their own mistakes is insane and creates a false sense of security.

  • Report this Comment On November 05, 2010, at 7:57 PM, tobernator1000 wrote:

    The problem with letting a bank fail is that you're left with two choices: Having the government/tax payers take on the bank's debts (via the FDIC or some other agency/legislation), or letting everyone who had money in that bank suddenly lose that money, causing a domino effect that creates a depression. Neither of these are acceptable options.

    However, we also need Savings and Loan type banks to provide liquidity, security, and credit to keep the economy rolling, so we can't just get rid of banks all together. The only reasonable solution is to regulate banks so that they can't gamble with OUR money. Banks behaved for a long time because they we heavily regulated, and as soon as we let them off the leash they (helped) engineer a crippling depression by hiding from almost everyone the lies that made their "business" possible.

    If we let things continue as they have been, we'll all be hiding money in a mattresses because we can't trust anyone to hold it for us, or creating a government organization to be a bank for us because we can't trust anyone with a mandate to make money. Smart, proactive regulation to keep a lid on the worst offenses and offenders will go a long way toward making America and the rest of the world much safer.

  • Report this Comment On November 05, 2010, at 8:43 PM, Pr0metheus wrote:

    Probably wouldn't hurt for regulators to enforce the basic fundamentals of conservative money management. For instance, limit a bank's portfolio to being no more than 20% exposed to any one sector, and restrict them to investing in companies that pay an annual dividend.

    May even want to restrict them to only long positions as well. If I can't go short in my IRA, I see no reason reason why they should be able to go short with the nation's deposits/tax dollars.

    -Bob

  • Report this Comment On November 06, 2010, at 12:20 AM, ET69 wrote:

    A socialist revolution would take care of this problem in a hurry!

  • Report this Comment On November 07, 2010, at 6:37 PM, tgc9184 wrote:

    Folks seriously ...the right thing is clear as day here......reinstitute Glass-Steagall. Separate the investment banks from regular banks that hold our deposits. It worked before...it will work again. Let Wall Street whine....the rest of us can celebrate

  • Report this Comment On November 08, 2010, at 9:14 AM, dfrizzle03 wrote:

    ET69

    your username explains where you belong...

  • Report this Comment On November 16, 2010, at 7:20 PM, easyavenue wrote:

    xetn,

    You fall prey to false logic and generalization in your remarks. E.g:

    Amen mikeness30. We already have way too much regulation and it is never enough. TOO MUCH..., ENOUGH? ONLY THE WILL OF THE PEOPLE CAN DEFINE THESE TERMS, AND THEY SAY KEEP WRITING. IT IS WHEN REGS ARE NOT IN PLACE THAT THE WORST ABUSES OCCUR. AS LONG AS "I'VE GOT TO GET MINE" MENTALITY RULES, REGS WILL RULE. POPULATION OVERGROWTH HURTS. Regulations really end up protecting some at the expense of others YES, THAT'S WHAT LAWS DO: PROTECT ONE FROM ANOTHER AND FROM/TO THE WHOLE. and ultimately add huge costs to businesses who then pass them on to the consumers. In fact, regulation is nothing more than a hidden tax. CORRECT. PROTECTION CAN NEVER BE FREE.

    And they are so ineffective that even when various attempts to inform the regulators about the ponzi scheme of Maddoff, they did nothing. FALLACY OF LOGIC: WHAT APPLIES TO THE ONE DOES not AUTOMATICALLY APPLY TO THE WHOLE.

    The best regulation is "let the buyer beware" THIS MUST ALWAYS BE THE MOST BASIC RULE. BUT DOES NOT FOLLOW THAT RIP-OFF ARTISTS (GETTING THEIRS!) SHOULD BE ALLOWED TO RUN FREELY. and vote with your money. ALWAYS. Trying to protect everyone from their own mistakes is insane and creates a false sense of security. EVERYONE?! LIKE YOU WOULDN'T HAVE GIVEN YOUR MONEY TO MADOFF IF YOU ACTUALLY HAD SUCH AMOUNTS. ARE ALL THOSE WHO DID SIMPLY S.O.L? THEY WERE SMART ENOUGH TO GET THE $$ IN THE FIRST PLACE, SO THEY COULDN'T HAVE ALL BEEN STUPID. I'LL BET MANY DID DUE DILIGENCE AND FOUND NOTHING. WHERE'S THE MISTAKE YOU RELY ON?

    ea

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