Today, October 11, we’ve been organizing our thoughts about the ongoing financial crisis. We’ll have more to say about ways to remedy the immediate crisis, but this post contains a specific recommendation for when the crisis ends, which today may seem to be far, far off. We’re sure that–whether justified or not–many laws and regulations will be revised and toughened, and this should be one of them.
We make this recommendation because from our experience and from the inferences that we’ve made about firms throughout this crisis, it seems that neither many senior managers nor regulators fully understand many prop trading activities although, of course, neither set of individuals would ever admit as much.
With government support comes obligations, including the commitment not to take outsized risks or ones that are particularly difficult to measure or approximate, and that seems reasonable to us.
In that regard, it seems very likely that the federal government will continue to provide higher levels of deposit insurance above the past limit of $100,000. Already that limit has been increased to $250,000, and there is talk of, at least temporarily, guaranteeing all deposits. (The guarantee of all deposits is stupid and counterproductive, and if it goes into effect, it will eliminate a useful disciplining and warning mechanism. Having large, uninsured depositors flee risky financial institutions warns managements to change and informs regulators of impending problems. We plan a separate post on that topic in the near future.)
Now, however, along with the indemnity that insurance provides should come the obligations of the insured–a quid pro quo if you will. It seems that the government has done a very poor job of setting risk-sharing mechanisms, i.e., the equivalent of deductibles, i.e., inflicting financial pain on the senior management when a bank fails–beyond the loss of share value.
We won’t comment on that aspect today; instead, we propose a limitation on insured-institution trading activities. Insured banks should not be permitted to have proprietary trading desks in their capital markets departments.
Note that this will not stop banks from harming themselves by (1) lending or (2) making bad investments or trades in their treasury departments or (3) mismanaging customer trading desks.
It will however, allow regulators to focus their attention on where the major risks are taken within the firms. Without going into details, we realize that their is a certain fungibility between treasury trades and prop trades in capital markets departments and to a certain degree between prop desks and customer desks in said departments, but it would seem to be more difficult to justify certain trades and strategies if the desks were within typical, bank-related business activities. (When could write much about this but it likely wouldn’t change minds; so, we defer.)
We’re completely for the free-market–more so than most bank managers–but until such institutions forsake their government insurance, we’ll insist that they have an obligation to the citizenry–through the government–to behave in a responsible, low risk manner. If that generates lower returns for them on average, then so be it. That’s the nature of the risk-return spectrum and their legal and fiduciary responsibilities.
By the way, if an all-in, full-accounting were ever performed, we’d be doubtful that such prop trading operations were profitable or value-creating, especially at the commercial banks. From what we’ve observed, trading PnL (profit and loss) is considered and sometimes trading-related PnL is considered for performance evaluation, but rarely an all-in accounting is performed. The marginal overhead costs risk-management, back-office operations, auditing, accounting, etc., associated with such activities are often ignored. Moreover, on a risk-adjusted basis, it is substantially less likely that overall, net returns are positive.
Finally, we actually think that many senior managers of commercial banks would welcome the ban. We suspect that many of them are suspicious of such activities but don’t feel qualified to evaluate and eliminate them. We think it is true of most regulators, too. They don’t object because they don’t want to seem unsophisticated; pride goeth before the fall.
