Eyes on the prize in financial reform #1: the Volcker Rule

The Financial Times’ Tracy Alloway has a nice piece that crystallizes concerns circulating among many observers regarding reforms to the banking system. New rules designed to increase the safety of the banking system are forcing banks to get smaller in a number of ways. But are these reforms just pushing the same risks off into the shadow banking system?

The public discussion is muddled in a couple of ways. A few useful distinctions can help to separate sensible concerns from baseless anxiety. A good place to start is the Volcker Rule. Alloway writes that “Some proprietary trading businesses that are no longer allowed at deposit-taking US banks under the Volcker rule have morphed into newly minted hedge funds.”

This is exactly what is supposed to happen. It does not reflect a worrisome expansion of the shadow banking system.

Proponents of the Volcker Rule do not condemn proprietary trading. It has risks, but there’s nothing wrong with private investors taking risks on their own account. The purpose of the reform is not to eliminate the risk taking. The purpose is to move the risk taking from where it doesn’t belong to where it does belong. Proprietary trades on bank balance sheets are a problem, since taxpayers are forced to shoulder some of the downside risk as well as some additional costs created by locating those risks together with other banking activities. Proprietary trades on a hedge fund balance sheet don’t present the same problem.

As an analogy, think of zoning regulations and other licensing requirements for the location of industrial activities of various sorts. For a host of reasons, oftentimes including safety, we try to locate these activities away from residential neighborhoods and away from sensitive environmental locations. The activities may be necessary, but where we put them matters to the public welfare. The same is true for proprietary trading.

This highlights the need to be more precise about the term “shadow banking”. It isn’t a catchall meaning any financial activity outside of the banks. It is meant to cover non-bank institutions performing quintessential “banking” services. What are quintessentially “banking” services? The most obvious one is maturity transformation: taking demand deposits and making loans. Maturity transformation entails the threat of bank runs and so requires public regulation. This is a major feature of the rules under which commercial banks operate. Shadow banking arises when other, non-bank institutions, not subject to comparable regulations begin to execute transactions that perform the same financial service of maturity transformation. And that is exactly what happened over the last several decades with the growth of the repo market and various channels for short-term lending such as money market mutual funds.

Proprietary trading is not a quintessential “banking” activity. True, many traditional banks also engaged in proprietary trading. But that doesn’t make proprietary trading outside of banks an example of shadow banking. If many traditional banks were to start a business designing video games, that wouldn’t make video game design outside of banks a part of the shadow banking system. Proprietary trading can be moved outside of the traditionally regulated banking system because it isn’t a quintessential “banking” activity requiring the same type of regulation that maturity transformation.

Of course, there are lots of complications to making this useful distinction. How the non-bank financial system, including hedge funds doing proprietary trading, interface with the banking system matters. Defining the full list of quintessential banking activities isn’t easy. And so on. But the distinction between quintessential banking activities and other financial activities is essential to guiding the financial reform, and can help to focus the public debate where it belongs.

Executives and managers at non-financial firms need to scrutinize proprietary trading under their roof in the same way. To what extent is proprietary trading core to the company’s line of business? Does it pose risks that can undermine the company’s core activities? Would the risks of proprietary trading be better managed if they were run on their own separate balance sheet? It’s not a question of whether proprietary trading risks are good or bad, but rather a question of where those risks belong in order for them to be properly managed.

One Trackback

  1. By Saturday Breakfast Links | Points and Figures on January 7, 2012 at 8:32 am

    […] thoughts on the Volcker […]

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