U.S. prop trading ban? Tough, but not impossible

By Dan Wilchins – Analysis

NEW YORK (BestGrowthStock) – Banking insiders insist that President Barack Obama will find it tough to rein in their risk taking, but risk managers and others say regulators really can make a dent in Wall Street’s casino culture.

Obama last week proposed a law that would bar banks from betting in financial markets with their own money, known as proprietary trading. Called the “Volcker rule,” after Obama advisor Paul Volcker, the law aims to prevent banks from taking risks that drag them to the brink of failure.

No sooner did Obama propose the idea than analysts and bank officials criticized the attempt to limit proprietary trading, in part because of the gray area between banks taking risk and helping customers.

Major banks with dealer subsidiaries are in the business of buying and selling securities and derivatives with clients all day. Sometimes, a bank buys an asset because a client wants to sell, and sometimes a bank buys because it likes the asset and wants to bet on its appreciating.

The White House said it does not want to interfere with banks trading for their clients, but the motivations for a trade are not always clear to an outsider.

Some risk management experts dismissed these concerns, noting that a few simple tools could go a long way toward limiting risk-taking.

“These problems are can be solved,” said one fund manager who formerly examined banks.

Banks could be restricted from holding onto positions for too long, or holding too much of a particular asset.

“Regulators can just say, ‘this trade has been on your books for too long, and it’s now a proprietary trade. You have to get rid of it,'” said Dan Alpert, a managing partner at boutique investment bank Westwood Capital.

Capital rules can also insure that banks have enough of a cushion to protect against losses in derivatives and securities positions.

And risk management systems can force traders to clearly identify the risks they are taking on their books, and how they are hedging that risk.

There is often ambiguity about whether a desk that trades with clients is taking risk, but there are clearer instances of betting that regulators can easily limit. For example, desks that do not trade with customers at all, or banks’ investments in hedge funds and private equity businesses, can clearly be stopped by the Volcker rule.

Regulators cannot and should not stop risk taking entirely, but they should reduce risk taking, the fund manager said. The trick will be to end the most egregious betting without making dealers too reluctant to buy and sell securities, which would increase trading expenses for investors.


Many traders are skeptical of the government’s ability to rein them in.

“How will a regulator know why I’m making a trade?” said one trader at a major firm.

One former corporate strategist at a U.S. bank said his department often was not sure why the bank’s own traders had exposure to an instrument or asset — whether it was for customers or to bet with the bank’s own money in a proprietary trade.

Steve Kohlhagen, a former university professor who built multiple derivatives businesses on Wall Street including at First Union, a bank now part of Wells Fargo & Co, argued that regulators lack the know-how to outsmart traders on abstruse financial products.

“Regulators can try to reduce certain kinds of risk, but it’ll just pop up somewhere else. It’s a constant chasing game that the government will lose,” Kohlhagen said.

Consider a corporate bond desk. A client might want to sell $1 million of IBM bonds. The trader would buy those securities, but she might not be able to sell them to another client for hours, days, or even months. In the meantime, she would typically lower the interest-rate risk associated with holding the bonds by shorting $1 million of Treasuries, or using interest-rate swaps. And she could buy credit default protection on $1 million worth of IBM debt to lower her credit risk.

But for each of these positions, the size of the appropriate hedge is subject to debate — for example, if credit derivatives tend to respond more to market movement than the corporate bonds, it might make sense to buy protection on just $900,000 of debt.

To an outsider, that transaction could either be interpreted as a sensible way to decrease risk or a bet on the credit quality of IBM. And when a trader has thousands of positions on her books, understanding the exact risks she is taking can be difficult.

Some institutions will be able to avoid facing the Volcker rule by shedding their insured deposits, according to U.S. Deputy Treasury Secretary Neal Wolin on Monday.

Goldman Sachs Group, which funds fewer than 5 percent of its assets with deposits, could easily change its funding profile to get out from under the rule.


Regulators, legislators, executives and investors in general do not agree how to prevent financial meltdowns.

Some, like Kohlhagen, believe that if Americans are not comfortable with regularly rescuing financial institutions, the biggest banks should be broken up into smaller ones that can fail without endangering the broader system.

The theory behind the Volcker rule is that large banks can benefit society, and dividing them up would make it harder for large companies to raise capital. Because the biggest banks have implicit government support, they should be heavily regulated to ensure they do not take outsized risk.

Many traders, bankers and executives on Wall Street oppose any kind of real legal or regulatory change. They blame the more than $1 trillion of write-downs and credit losses the financial industry racked up in 2007 and 2008 on a series of unfortunate events rather than a lack of oversight.

But those arguments reveal the vast divide between Wall Street and Main Street, regulatory experts said. Changing nothing increases the chance of more big meltdowns, and is not acceptable politically.

“Nothing is easy, and I’m sure banks will lobby the daylights out of the current proposal, but reform is necessary, and in the end the rules will likely be changed,” said Karen Shaw Petrou, managing partner at Washington research firm Federal Financial Analytics.

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(Reporting by Dan Wilchins; Editing by Phil Berlowitz)

U.S. prop trading ban? Tough, but not impossible