Prop Trading and the Volcker Rule

| Fri Apr. 30, 2010 1:11 PM EDT

Mike Konczal interviews Jane D’Arista, a research associate at PERI, about the Volcker Rule and its proposed ban on proprietary trading by banks, the part of their business in which they borrow money to trade on their own accounts:

Prop trading only works if [banks] can borrow enough to substantially leverage their own capital. They have to set up a situation in which the cost of borrowing is lower than the return on the assets or derivatives in which they are investing. One example is what they are doing right now — borrowing very cheaply from the Federal Reserve and earning 200 basis points, let’s say, on buying Treasury securities.

....The only way prop trading is profitable is if the scale is enormous, especially in periods of low interest rates when margins are thin. Also because there is — has to be — a maturity mismatch to generate that margin. Except in rare periods when yield curves are inverted, low interest rates are available if borrowing is short-term lending and the desired higher rates on investment are available on longer-term assets. There is a liquidity risk if something happens in the market and the cost of rolling over the short-term borrowing rises....Every time there’s been a shock — Franklin National in 1975, Continental Illinois in 1984, Long Term Capital Management in 1998 — one or more big institution was not able to cover its position because its short-term funding disappeared and central bank liquidity had to be rushed to the rescue.

....Now people might say if we remove the prop trading desk from the firm its no less risky because it will be outside the firm, its like were not going to make it less risky, it will just move it around. What should people think in terms of taking the prop desk out of firms that have access to the fed window?

....What’s important about the ban on banks is that you end the channel through which the backup to the Fed creates the moral hazard that supports excessive risk. If the amount of funding banks can supply to one another and to other financial institutions is curtailed, prop trading will have to shrink because the repo market will shrink.

That’s what section 610 of the Dodd bill would do, shrink the repo market. It would restrict loans by banks to other financial institutions, requiring that the same limit on loans to a non-financial borrower in relation to capital that has been in effect for over a hundred years also apply to financial borrowers. In the case of financial institutions, the limit would apply to credit exposures involving repos, securities purchases and sales and a very broad list of derivatives.

....The growth of the offshore banking market and the invention of the domestic repo market [in the 90s] dramatically raised the amount of intra-sectoral borrowing and brought the issue into focus....About the same time, the Gramm-Leach-Bliley act gave permission to banks to borrow more for both necessary and other reasons — that is, to increase the share of non-deposit liabilities on their balance sheets. So they set up this whole interconnection game in which they borrow from one another and, in the process, are creating liquidity by monetizing debt. Of course, its all on paper — its all a pyramid — and in the end it can collapse and did.

The solution is to limit the funding that goes into prop trading as well as banning the trading itself for those institutions that have access to the Fed. And if that were done — if section 610 became law — even the investment banks wouldn’t be able to engage in excessive proprietary trading because they couldn’t get the funding to do so.

The whole thing is a little long and wonky, but worth a read. And while you're at it, if "off balance sheet" is a mystery to you, you might want to check out Mike's interview with UMass lecturer Jennifer Taub as well. It's good tutorial stuff.