Tom Brathwaite made an interesting observation in his Financial Times piece “Volcker conundrums fuel confusion over rule” (12/20/11). Wall Street banks are counting on their ‘less-tainted’ rivals, the non-bank affiliated Asset Management firms, to lobby on the banks’ behalf and protect them from the Volcker Rule’s market making restrictions.
“The banks have cried wolf so often on financial regulations that they are likely to be ignored. But there is some substance this time. And if the likes of Goldman Sachs and Morgan Stanley get a deaf ear in Washington, their only hope is that less-tainted financial institutions will have more success.”
The idea that Washington is turning a deaf ear to the likes of Goldman Sachs and Morgan Stanley sounds a bit off-key. What is perhaps even more curious is the fact that the independent Asset Managers, as non-banks, are immune from the Volcker restrictions on proprietary trading and market making. So what’s really going on?
Alliance Bernstein’s Volcker comment letter broadcasts a fear that prohibiting banks from market making will have a disruptive effect on global markets until replacement market makers emerge. They argue that the market making restrictions at the banks need to be relaxed in order to mitigate this disruption. Lord Abbet makes the same case and describes the interrelationship between proprietary trading and market making during the ’08 meltdown.
“If dealer banks had been prohibited from building positions and were instead forced to find a buyer for every security sold, prices would have fallen much further than they did. Banks were able to absorb the avalanche of high-yield securities in their trading accounts and were at the same time able to perform a function that long-only asset managers could not: hedge the risk.”
Under the Volcker Rule, a bank’s inability to absorb an avalanche of high-yield securities in its trading accounts isn’t a bug, it’s a feature. High yield securities remain at artificially inflated levels precisely because the banks can still absorb them in their trading accounts. The Asset managers are making the regulator’s market making limitation case for them.
There is no evidence that the current level of trading activity is desirable or optimal; indeed, numerous proposals to implement transaction taxes are based on the view that the amount of trading activity system-wide should be reduced. Volcker is designed to curb speculative position-taking at government-backed banks. It is the regulators’ responsibility to ensure that trading activity migrates out of government-backstopped banks. Regulators should not take measures to preserve the current level of trading activity. If trading is not economical when no longer supported by artificially cheap funding, that likely means that it does not serve a legitimate real-economy purpose. Restricting market making at the banks removes a source of artificially cheap funding to the market.
It appears that many pundits and Asset Managers assume that a priority of the regulators writing the Volcker rules is to maintain the status quo in spite of the statute. In fact, their arguments actually strengthen the regulators’ hand to change the status quo. Simply put, the proprietary trading and market making definition need to be tightened.