Notebook, 15 June 2012: Beyond the Volcker Debate

William K. Black: “The scale of fraud is immense.”

Just for starters, let’s stop calling JP Morgan Chase a “bank.”

Tim Ryan is CEO and president of SIFMA, the Securities Industry and Financial Markets Association, the lobbying arm of a broad coalition of Wall Street (let’s not forget Chicago here) traders and brokers, tries to recast the debate and the “will of Congress” in response to comments made by CNBC economics reporter Steve Liesman on Jamie Dimon’s testimony on the proposed Volcker Rule. Ryan erroneously claims that regulators are thwarting the will of Congress by proscribing activities Congress specifically wanted banks to perform. This isn’t exactly accurate (Congress couldn’t agree to any substantive measure and sent mixed messages), but let’s skip that as besides the point for my purposes here, except to say that proposing a quantitative risk ceiling is a real proposal which I never expected to hear from SIFMA, which has a history of distancing itself from the truth and playing legislative hardball. Kudos to Tim Ryan. (Some things are really hard.) Quantitative risk ceilings and quantitative baselines are indeed needed throughout the financial services sector.

My problem with the Volcker Rule is the same as Jamie Dimon’s, and indeed of Paul Volcker himself. It is too complex. I lay the blame mainly on Congress, who adopted a ban on prop trading but did not want to rock the boat enough to actually do it. This is made clear both in statements made by legislators and in the law itself. Be that as it may, we should face up to the fact that anything taking this long to write probably won’t be worth the effort in the end. Again, I blame Congress. This is exactly what their compromises were intended to do throughout the Dodd-Frank (pdf, 2000 pages) debate, a compromise which allows banks to do pretty much what they were doing before. Dodd-Frank’s aim is to protect a status quo which for a lot of reasons is not worth protecting. Do we really need banks to make markets? Or to finance, using the rules of prudent lending, the market makers?

As soon as the law was enacted, the hair-spliting began, and with the example provided by the $2 billion loser of a trade by the investment arm of JP Morgan Chase in London, we now have real life example to judge one part of that law, the Volcker Rule by*, and it is anything but clear whether the rule:

  • Would have classified what is variously named portfolio hedging, aggregate hedging and macro-hedging as a prop trade or a permitted trade in the course of “normal hedging”
  • Would have provided regulators with timely notice of the size and structure of the trade, which was conceived and executed in London, please note, so they could rule on it’s status

Ryan makes what would seem a sensible proposal: come up with a formula which quantifies the allowable levels of risk, in much the same way banks measure risk. (Dimon cited in his testimony the hundreds of algorithms JP Morgan uses to measure risk, all of which are closely guarded proprietary secrets.) I say that it seems like a sensible proposal except for one fact: no model exists which accurately describes the risk environment banks face. VaR (Value at Risk) is, like all other risk models, bound within what is easily quantified and therein lies weakness in these models. Indeed, all “scientific” economists tend to interpret these kinds of measures as proxies for the great, imperfectly-grasped churn of economic chaos. Time and again, we’ve witnessed these kinds of models fail, yet they’re the best thinking we’ve got, so we run with it. Again, a larger issue I won’t even begin to tackle here, but it matters in this discussion because Ryan’s proposal takes us nowhere.

Because Congress took us nowhere. Dodd-Frank is, contrary to any claims made otherwise, an attempt to save our financial markets, not an attempt to reform them. As time has passed, we have learned much about the culture (and here) and activities of Wall Street, going back decades. We know without any doubt whatsoever that Wall Street has infiltrated Washington to the extent that banks have been regulating themselves for decades. Dimon holds an important post on the NY Fed. Once an US Attorney, Mary Jo White now argues the case for some of the biggest Wall Street firms. John Dugan, once chairman of the Office of Comptroller of the Currency, has recently returned (lets be serious, he never really left) to his post at the bank lobbying firm Covington and Burling, which is also Eric Holder’s alma mater. Those are just a tiny, tiny handful of names.

Congress and the Obama administration have not stepped up to do the job they are supposed to be doing, so we’ll have to. The real debate isn’t about the Volcker Rule and Congress’ intent, but about what the American people really want:

  • A sound financial system we can be confident of
  • Markets that are free, bur fair
  • Regulators who are on the job doing what we pay them for: keeping the scammers at bay
  • A justice department that enforces the laws and regulations designed to prohibit and punish those who abuse the trust of market participants, especially the retail investor
  • A financial system safe from situations where we, the taxpayers, have to bail them out

So in the spirit of Jamie Dimon’s request for clear and simple regulation I propose a return to Glass-Steagall, only more so. In 1934, when Glass-Steagall was enacted, financial services companies didn’t yet exist, but beginning with the CitiCorp acquisition of Traveler’s Insurance (who already owned an investment bank), this has changed dramatically. Commercial banks which take your deposits are now investment banks playing the markets. They are our insurance companies. They function as prime brokerages. Whether or not they have in-house hedge funds trading on their own behalf or not, they are, in fact, themselves hedge funds. While taking deposits through JP Morgan’s acquisition of Washington Mutual, the list of things banks do, from JP Morgan’s own website inclides:

  • Investment Banking
  • Equities
  • Fixed Income
  • Foreign Exchange
  • Commodities
  • Risk Management
  • Prime Services
  • Emerging Markets
  • Structured Products
  • Research
  • Global Corporate Bank

Apart from the fact that, through FDIC insurance on those deposits, taxpayers are at risk of bailing out those depositors, JP Morgan is America’s largest financial services company, and all on its own poses a grave, systemic risk to all of us, whether we own shares in JPM or not. Whether we bank at WaMu or not. Whether we manage our assets through them or not. Whether we invest our retirement savings with them or not, or whether we do business with one or more of JP Morgan’s units. For JP Morgan Chase participates in almost every type of financial service there is from governments and the world’s largest banks and corporations right down to the individual depositing a paycheck, taking out a mortgage, saving for retirement, buying insurance (a service JP Morgan itself does not offer) or paying for a child’s education. I propose we break all that up. For simplicity’s sake. For ease of regulation. To solve the too-big-to-fail problem and deal with it’s systemic risk. To solve the too-big-to-run problem so aptly demonstrated by this $2-plus billion fiasco coming out of London. Furthermore, I propose we start thinking seriously of making commercial, deposit-taking banks a public utility, protecting it from competition while guaranteeing a modest profit. In addition, we should consider defining the practices of market makers and restrict them to those practices. Perhaps we should clearly delineate the roles and practices of investment bankers as well. All this, while of course, keeping these different business models and skill sets separate companies and further restricting the capacity of banks of all kinds in the interests they can take up in non-banking entities, if any. Over and above isolating risk as much as possible, conflict of interest and the potential for market manipulation are two concerns I have in this regard.

Simple, clean, easy to grasp, much easier to regulate, much easier to detect and punish violators, and still preserves enough room for flexibility and innovation. You will note that I’ve said nothing of private equity or hedge funds here, and that is deliberate. If an individual banker wants to indulge in opening and running an hedge fund, has an idea believed to be the better financial mousetrap, he or she can do so, provided he leaves the bank and does no business with the bank he or she is quitting. (Conflict of interest is the concern here. Sweetheart loans played a significant part in the S&L Crisis.) The paradigm for regulation I propose here is prescriptive rather than proscriptive. An important difference which should answer almost everyone’s complaints about the complexity of regulation, and is, incidentally, something very much like the banking landscape prior to 1978. Financial services should be the offerings of independent brokers, not of single corporate entities.

Congress gave us what should be apparent to all by now, a rule impossible to write well, impossible to enforce well, and subject to the protestations of bankers as well as the subjective judgements of regulators as to whether a trade is permitted or not. We cannot even come to a consensus on whether a hedge on the bank’s own portfolio or more specifically, whether, even when a bank tells regulators the trade is a hedge linked to any asset or collection of assets (a proposal floated by OccupytheSEC), is a prop trade, or not? Nobody can say. It is open to interpretation by the regulators, who are themselves industry insiders.

Forget that we, as taxpayers, are ultimately liable for FDIC insured deposits. Forget that we, as savers, have kicked in $6 trillion into the riskiest sectors of Wall Street since 1976 through a federal tax subsidy. We are all stakeholders, nonetheless. We are all captured; there is no freedom of choice here because this is the only economy available, and banking lies at its very heart. The big takeaway from the last thirty years is that society has every right to protect itself from bad banking, and we need to protect our bankers, as it turns out, from themselves. Sooner or later, we’re going to realize how inadequate this latest attempt at proscriptive regulation is. The sooner we get around to really reforming finance, to prescribing the business models of systemically vital sectors, the better off we’ll be.

There are other issues involved here, one being how the American taxpayer is vulnerable because another country takes a lax position on regulation. Make no mistake, London is the home of the financial buccaneer, and that ought to rankle. Financial markets have gotten out of hand as well. The entire world’s GDP is around $65 trillion annually, yet somehow this can be leveraged into over $700 trillion in OTC derivatives. Which can happen, perhaps should happen to some extent, but this seems excessive. Then there is the growing banking system which operates under the supervision of non-bank companies, like General Motors and it’s lending arm, GMAC/Ally Bank. Who knew that General Motors was deeply involved in the mortgage market? No wonder they needed to be bailed out. We should take all this right back to Congress and demand they get the thing right this time. To Tim Ryan I would point out that since Wall Street is still construed essentially as it was in 2007 should be all the proof anyone needs about the intent of Congress:

Washington wants big finance because it is owned by big finance.

*Please note that in his testimony, Jamie Dimon claimed that the original position was too risky, and that he ordered his investment office to unwind it, and that instead of doing so, they added to it with other trades designed to hedge against that position’s potential losses, that it “morphed” (his word) into something else. What’s the truth here? Was it the original position which blew up or the hedge?


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