Proprietary Traders Earned ‘Trust, but Verify’: Simon Johnson

There are two ways regulators can keep tabs on proprietary traders and their equivalents who can win big betting their firm’s capital or lose even bigger and threaten the world financial system.

We can have a part-time lapdog, which is surely what the banks want, or a guard dog who keeps an eye on them 24/7. Given everything that happened in the run-up to September 2008 -- and in the two years since -- it’s pretty clear what we need, though it remains up in the air what we’ll get.

The Financial Services Oversight Committee met for the first time last Friday. As required by the Dodd-Frank Act, the committee issued a request for comments on the proposed application of the Volcker Rule, which requires, as insisted upon by Senators Jeff Merkley and Carl Levin, that large banks cease to conduct proprietary trading and significantly limit their private-fund investments to 3 percent of capital.

The request for public comments now is posted on the committee’s website and comments are due by Nov. 5. The committee needs to make its recommendations by Jan. 22.

Behind the scenes and inside the regulatory debate, there are two opposing sides developing with regard to how compliance with the Volcker Rule should be monitored and enforced.

On one side is the view that compliance should be monitored only through periodic existing supervision and some spot checks. This was the position that Federal Reserve Chairman Ben Bernanke took before the Senate Banking Committee last week. His idea seems to be that the industry will follow instructions and only needs a moderate degree of broad-brush enforcement.

Another Side

On the other side is the view that enforcement should be more assertive and based on real-time access to detailed trading data. The thinking here is that regulators would need the ability to look at transaction data to understand what is really going on.

At the same hearing last week Securities and Exchange Commission Chairman Mary Shapiro seemed to take this more trade- by-trade approach to monitoring and enforcement.

Why not do both? This is the position taken by Merkley and Levin in a conference paper that came out this week.

I testified in favor of the Volcker Rule in February to the Senate Banking Committee on a panel alongside representatives of Goldman Sachs Group Inc. and JPMorgan Chase & Co., and we disagreed completely. Given the adamancy with which they argued so recently against the Volcker Rule, it isn’t unreasonable to wonder about their intentions now.

Easy to Disguise

If a bank’s management wants to take proprietary risks using its own capital, these would be relatively easy to disguise on a trading desk as “customer flow” in some way. Some big banks have already announced that proprietary trading jobs will be cut, including at JPMorgan after the firm reportedly lost $250 million on coal trades in the second quarter (although perhaps these developments are not connected). Bank of America Corp. has announced that proprietary traders will be switched to other jobs within the firm.

But as my colleague Michael Lewis asked last week: how would anyone know whether proprietary trading reappears in disguise? Lewis also pointed out that, at least in the case of Goldman Sachs, some of the most important transactions with regard to committing or protecting the firm’s own capital in the recent past were undertaken by their so-called Client Facing Group. This doesn’t imply there was any deception, simply that risks can be placed in any number of locations within such an organization.

Betting Big

We know that big banks like to bet big, particularly as the credit cycle develops. Sometimes this goes well for them and their shareholders, and other times it goes badly as it did for Goldman Sachs when it reported losses on equity derivatives in the second quarter. When large bets go bad the damage can be so catastrophic that the entire credit system is disrupted and the tax payer is again on the hook.

Whatever you hear from politicians, there is no way to handle the failure of global megabanks because there is no cross-border resolution mechanism or bankruptcy procedure that can handle their failure, a point I made with co-author James Kwak in “13 Bankers.” The idea that too big to fail has been legislated away is simply an illusion.

There is nothing anti-business about wanting to enforce the Volcker Rule. Quite to the contrary, the severity of the financial collapse in the fall of 2008 was very much about how big banks acquired and mismanaged huge risks -- not all of which were within officially designated prop-trading groups -- and in the process damaged the rest of the financial industry and the broader economy.

On the Sidelines

You can stand on the sidelines or you can send comments to the committee; they will only ask once. If you care about future financial stability and regard the ability of big banks to endanger the system as unnecessary and inappropriate, you should consider sending in comments to that effect.

The Volcker Rule may not be perfect but at this stage it’s almost all we’ve got. And with regard to voluntary compliance by the big banks, we should reflect on Ronald Reagan’s thinking with regard to nuclear disarmament commitments by the Soviet Union, “trust, but verify.”

(Simon Johnson, co-author of “13 Bankers: The Wall Street Takeover and the Next Financial Meltdown,” is a professor at MIT’s Sloan School of Management and a Bloomberg News columnist. The opinions expressed are his own.)

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