My Ramblings On the Volcker Plan

This week, the Obama Administration turned their attention away from healthcare and towards the banks, announcing the Volcker Plan.   While the official plan hasn’t yet been released, the blog and tweetosphere have been buzzing over the last few days.  The reactions have ranged from angry to confused.

I figured I would share a few of my thoughts:

  • It will be very difficult to define what prop trading is. Two great pieces that illustrate this point are Kid Dynamite and Bronte Capital.  That does not mean that it can’t be intelligently done, but it will be difficult (and unlikely).  This issue is not simple and those saying it is on either side are wrong.
  • This is political but the ends can still justify the means.  While this is obviously a political reaction. it doesn’t mean that it should be completely ignored and written off.  Let’s be honest here, EVERYTHING that comes out of Washington is political.  Many people who were criticizing Obama for not putting forth financial reform are now criticizing Obama because he did.  Yes, what he is proposing is not the solution, but criticize the idea not the man.  If there is one thing that both sides of the aisle can agree on is that there needs to be some financial reform of some sort.  The masses will be happy with something, so it should be in the interest of all incumbents to come together and pass something good.  I don’t agree with Obama on many issues, but still would like to see him pass some meaningful financial reform.  We must be constructive in how we approach this, not destructive.  Use this as a launching pad.
  • Just because prop trading didn’t cause the financial crisis doesn’t mean it can’t. A popular argument against the proposed reform is that it doesn’t address the causes of this crisis.  This is absolutely true.  This crisis wasn’t caused by prop trading (although it was a Bear Stearns internal hedge fund which helped to get the ball rolling).   This doesn’t mean that the next one can’t be.  Most would agree that reform shouldn’t seek to be solely punitive in nature nor should we engage in regulating in the rear-view mirror.   It doesn’t address specific causes of the last crisis, but does address a more general, timeless, and universal one – mixing opaque risks with customer deposits.
  • Just because something makes up a small percentage of a banks business or all bank business doesn’t mean it can’t present harmful risk into the system. In today’s WSJ Intelligent Investor Jason Zweig writes:

    But the bad behavior on Wall Street in the 1920s wasn’t really caused by the blurring of commercial and investment banking, according to financial historian Eugene White of Rutgers University. Of the more than 7,500 banks in the U.S. in 1929, only 3% had significant securities operations. Nor did hawking investments make banks riskier for shareholders. From 1930 through 1933, nearly 2,000—or more than 26%—of federally chartered banks closed. But only about 7% of the banks that had a securities business
    went bust.

    Yes this is true, but the problem which caused the bank run in the 30’s was that some banks were holding the bag on worthless stocks.  This fear grew to speculation that ALL banks had this exposure.  If you remember this is similar to what happened with subprime.  Everybody was asking is this bank or that bank subprime.  Subprime loans were a small percentage of the total assets on the balance sheets but caused a disproportionate amount fear. Fear is a powerful emotion and if you look at the opacity surrounding some principal investments banks invest in, it isn’t hard to see this happening again.  It’s best to keep risks surrounding customer’s deposits as simple and transparent as possible. While this proposal isn’t as far-reaching as Glass-Steagall was, I don’t think the original law was completely unfounded.

  • This isn’t going to kill market-making as many people are claiming.  One of the biggest options market maker is Citadel.  Citadel is a hedge fund, not a bank.   There is no law in finance that says the same place I deposit my money has to be making markets in securities.   Market makers provide a valuable service to the market place – liquidity – and they get paid a spread to do so.  It also helps dealers underwrite and provide capital.  It is a business that is obviously viable on its own and existed before Graham-Leach-Bliley.  If prop trading is something that helps facilitate market making perhaps the whole enchilada should be separated.
  • Most large financial supermarkets failed, why argue against reality?  Citi and Bank of America (and Wachovia) should be a referendum on Graham-Leach-Bliley.  In the 1990’s, the bill was introduced in order to put the Citigroup merger through.  Citigroup has failed and is still on government life support.  There is nothing that has happened that convinces me that this is the model that works, so why fight to save it?  To those that scream “FREE MARKETS!”, the market has spoken and it said it doesn’t like these large financial institutions. Without government intervention they would already be dead by now.

Those are some of the ideas that have been bouncing around my head the last few days.   As I was writing this, The Epicurean Dealmaker shared an interesting FTAlphaville article that says how the proposal also helps crack down on some conflicts of interest on Wall Street and indirectly on pay, that is worth reflecting on as well.

I welcome comments, criticisms, and ideas.  I think those looking for reform have been given a gift here, as reform is now back on the agenda.  Instead of attacking the idea we in the blogosphare should be thinking more deeply, constructively criticizing, on it and improving it, because hopefully they are listening.


  1. I think you’ve made some valid points here and concur that this is not in and of itself going to cause a crash in the market. It is however worth saying that a small force is all that is necessary to cause a precariously balanced object to fall.
    The market reaction probably would have been muted but for these things
    1) The timing reeks of political motive and promotes a lack of trust in Mr. Obama and his administration
    2) The plan itself is not fully formed, so while the idea of removing the government backstop for these banks taking extreme risk with taxpayer low interest money is a good thing, the proposal does not specify how it will go about doing so. The market does not like uncertainty
    3) The potential for a firesale of assets that would occur should the banks be made to divest rapidly.
    4) The potential for these banks to lose a valuable income stream.

    If folks don’t want or think financial reform is unnecessary they are as you say wrong. But if the administration is seen as endeavoring to achieve financial reform by taking politically motivated shots in the dark, they will not achieve their goal and the equity markets will continue to decline.

    Thanks for your continuing good work on this blog

  2. zerobeta

    Thanks for the comment, and I agree with many of your points (and your post)

    One reason why the plan might not be fully formed yet is because he wants to gauge the reaction and get feedback, which could be the right way to put forth such a proposal. Perhaps this is a bit idealistic but regardless, we shouldn’t be attacking him right now but attacking the idea and improving it.

    Banks may lose a valuable income stream but they also might lose a harmful risk. Risk/return is the cornerstone of finance. Regulation shouldn’t be put into place to maximize bank profits but to ensure systemic stability. Once the rules are set in place banks are free to maximize their profits however they wish, but the right rules should be first be in place to ensure that they aren’t maximizing profits at the expensive of stability.

    It’s definitely a political move, but in order for Obama to get anything done he needs the people’s support again because he’s lost it. He doesn’t even have support from his own party because they are so worried about being reelected. So its pragmatic in a sense that it allows him to do something/anything.

  1. 1 Sunday links: strategic defaults Abnormal Returns

    […] or all bank business doesn’t mean it can’t present harmful risk into the system.”  (Zero Beta also WSJ, naked […]

  2. 2 Nationalizing Market-Making « zerobeta

    […] 3, 2010 in Markets, Politics, Technology As the Volcker Plan limps through Washington and many are screaming bloody Armageddon, an idea has been floating […]

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