The thin edge of the wedge…

This past week has seen Barack Obama fire the first meaningful salvo across the banking bows in the world of financial re-regulation. In short summary, his new proposals would ban banks with government insured deposits from taking punts with their own trading funds, and furthermore would prevent banks from owning, investing or sponsoring hedge funds and private equity funds. Obama has also called for new caps on the size of banks, to limit the damage that a failure could inflict and to promote healthy competition.

Proprietary trading, it’s arguable, serves no great economic interest. On the one side it’s suggested that proprietary trading desks at banks do increase the availability of “risk capital”, which means that more funding is available to corporations in the “real economy”. As the credit crisis has shown, however, much of this capital is not “consistent capital” – it is sufficiently whimsical that it actually increases the volatility of the system as a whole.

In reality, more often that not, proprietary trading does little other than enrich the traders at the banks taking these risks, who are in the ultimate “heads I win, tails you lose” scenario. If their gambles pay off they get paid fantastically well as individuals, but if it goes wrong then the shareholders, bondholders, the FDIC and ultimately the taxpayer carries the can (it should be in that order, but even that’s been shown to be untrue).

All in all, Obama is talking about some fairly sound stuff in principal – it would be fantastic to develop a system such that banking mistakes are borne by those who have invested in those banks, and that the “spillover” effects (externalities for all the economists out there) of undertaking risky business are minimised. Obviously if bank deposits are insured by the FDIC, then they too deserve to bear the brunt as in effect they are effectively an “investor of last resort”, but the FDIC or any other government body should not be holding the liability for a private sector institution failing unless they are being paid adequately to take that risk.

All very good stuff in theory as I say, but the practical realities of implementation are going to be very difficult to sort out.

Where the line is drawn between “proprietary” trading and “real” financing is going to be very hard to pinpoint. The Obama plans seem to apply to both banks and bank holding companies, for example, but there is a huge difference between them. A bank is chartered by the government, its deposits are insured, and it can access the Federal Reserve’s discount window. None of these things are true for a bank holding company – which is an ordinary corporation that controls a bank. Because banks are government backed, and privileged in many ways, their activities are limited by law (or at least they are supposed to be). They are restricted in how they can use their insured deposits.

The Glass-Steagall Act does actually still apply to banks, despite what some media commentators seem to suggest; it forbids them from engaging in underwriting or dealing in securities – so consequently this should prevent them from engaging in proprietary trading to the extent that this is dealing in securities. Merely enforcing the law that’s in place here, might have clear benefit. Bank holding companies (as Lehman Brothers was) can engage in any financial activity, including securities dealing – so as they have no implicit government backing then how can they be forced to stop?

Apparently, the argument from Obama is that bank holding companies should be prohibited from proprietary trading because it’s too risky. He may have a point – look what Lehman’s punts in the real estate markets unleashed for the whole of humanity when they went wrong. In the world of practical realities, however, there are 2 major issues:

1. Where do you draw the line on what qualifies as proprietary trading?

If an institution makes a loan to a company – let’s take the example of RBS’s much criticised participation in Kraft’s buyout of Cadbury – they are making the loan on the basis that they will generate a rate of return on the portion of the loan that they keep, they will get “arrangers fees” and thirdly will look to re-syndicate (sell on) a good chunk of the £11bn reported funding figure. Are they proprietary trading in any of these capacities?

Many banks will argue that their “pure proprietary trading” revenues are quite small as a proportion of overall revenues (see Goldman’s) – they will do this because quite rightly their shareholders think that prop trading is quite risky – the revenues generated are certainly riskier than the revenues from “advisory” type business, where fees are paid for advice given. When Lehman got itself in a bit of a pickle, it had financed huge loans in residential and in particular commercial real estate markets. For example Lehman lent £1.4bn on the purchase of the Coeur Defense building it purchased in Paris in 2007 (one of the loans that ultimately killed the bank) – at the time of the loan, Lehman intended to securitise (resell) a good chunk of this loan quickly. Was that proprietary trading, even though none of the world’s banks who were doing similar would have categorised it as such. Similarly – as I wrote about last week – were Goldman “hedging” themselves or punting when they bought AIG credit default swaps – there is a strong case to say it was the latter.

2. The second practical issue is what types of institutions should be limited in their “proprietary trading” capacity. Lehman Brothers was a bank holding company, so therefore outside of the remit of the government protections provided by FDIC. Understandably Barack Obama is trying to protect the system against failures of these types of institutions, but the interconnected nature of large financial institutions ranging from bank holding companies, to pension funds to hedge funds means that the scale of the potential restrictions in the world of proprietary trading would need to be huge.

A hedge fund like Blackrock has $3.2 trillion worth of assets under management – more than many banks. It’s owned by Merrill Lynch, PNC Financial and Barclays. Under Obama’s plan these holdings would need to be divested by these banks. Presumably, as well, any lending to Blackrock by banks would need to limited so that the success or failure of Blackrock’s investment punts wouldn’t materially affect the banking system. Blackrock engages in significant investment in all sorts of industries the world over, and much of it’s activity is crucial in the process of capital formation that forms the bedrock of economic growth – companies with good ideas need risk capital to turn good ideas into reality and to create jobs and wealth.

When the venture capitalists that put money into Google early on they knew that there was a good chance of failure – but they did it anyway. The job creation and wealth effect of their decision has been proven over time to be clearly in the broader interest of society (perhaps not Chinese society).

If the financial system doesn’t foster a level of risk taking then the economic consequences will be as great as if too much risk is taken. It’s clear from the credit crisis, that there was too much risk being taken by many institutions that were all connected to each other.The tricky implementation issue for Barack Obama is finding an acceptable balance. Does he limit proprietary activities at just banks, or bank holding companies or does he need to individually address hedge funds or even pension funds? If so, then how does he do that without perversely affecting the risk- taking that’s critical to a free-market economy working properly. The theory is good though.

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