In a night out that only a compliance geek would love, I
spent Monday night listening to Malcolm
Salter talk with Paul Volcker, former Chairman of the Federal Reserve.
Harvard University's Edmond J. Safra
Center for Ethics and the Center's director, Lawrence Lessig, hosted the
event in the Ames Courtroom at Harvard Law School. The topic, as you might
expect, was Implementing
It was clear that Mr. Volcker is a supporter of
traditional commercial banking. He stated that they are essential to commerce.
Their core functions of taking deposits, making loans, and operating the
payment system are essential and need to be protected. There is a price for that
protection: government oversight and restrictions.
The 2008 crisis came from non-banks. Hedge funds and
investment banks touted their efficiency, lack of regulatory oversight,
brilliant managers, and best financial engineers. In 1998 they invented Credit
Default Swaps. They blew themselves up.
There were $60 trillion of CDS instruments insuring $6
trillion of loans. Today there are $700 trillion of the greater category of
derivatives. That is an order of magnitude larger that the world's GDP.
Mr. Volker was quick to point out that proprietary
trading was not the cause of the 2008 crisis, it was the origination of many,
many bad home loans to people who could not repay them. However, proprietary
trading did play a role.
Mr. Salter pulled out a thick binder contained the
proposed Volcker Rule. (I did the same thing at the PEI CFO Forum.) But
Mr. Volcker found that disingenuous. The rule itself is only about 35 pages and
the rest of the binder contained the commentary and thousands of questions
posed by regulators.
Mr. Volcker compared the current rule on proprietary
trading to a rule on Truth in Lending that he implemented while he was Chairman
of the Federal Reserve. The initial draft from his staff was 170 pages, he sent
it back with a requirement that it be no more than 100 pages. He wanted it
simpler and they delivered. To his surprise, most of the industry comments were
to have more details in the rule.
It became apparent to me that Mr. Volcker was advocate of
a principle-based oversight rather than a rules-based oversight. The more rules
there are, the more gamesmanship that the industry will engage in. He pointed
to the example of Barclays and Deutsche Bank re-shaping their US subsidiaries
so they would no longer be classified as bank holding companies. He thinks it
will be relatively easy for regulators to spot proprietary trading by focusing
on volume an volatility.
Switching topics, Mr. Volcker pointed out that the
standards for bank capital requirements were another part of the 2008 crisis.
Under the regulatory capital requirements, banks were not required to set much
capital aside for mortgages and sovereign debt. There is some backlash in
the Volcker rule because it allows proprietary trading in US government securities,
but not in non-US sovereign debt. That has been the case for many years, going
back to Glass-Steagall. The problem is drawing the line between which sovereign
debt is safe and which is not.
Mr. Volcker does not think that the proposed rule is on a
deathwatch. Rule-making is inherently complex and this is a complex area. To
add to the complexity, several government agencies are involved in the rule. He
also pointed out that much more lobbying and money is involved in the
rule-making process than when he was Chairman of the Fed. You want industry
responses to rules. The difficult part is when that response is coupled with a
campaign contribution to Congress.
Circling back to the ethics aspect (the event was
sponsored by the Center for Ethics), Mr. Volcker pointed out that proprietary
trading causes an inherent conflict of interest with your customers. The trader
is no longer acting as a broker, pulling a buyer and seller together. The
proprietary trading bank is buying and selling for its inventory.
Proprietary trading creates a conflict in the
compensation structure. Traders get paid on short-term gains, often before the
trade's economic effect is fully realized. That outsized and short-term
compensation becomes a siren song for bankers looking for fatter wallets,
causing them to take bigger risks. (Like, say originating sub-prime loans and
additional commentary on developments in compliance and ethics, visit Compliance Building,
a blog hosted by Doug Cornelius.
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