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Why the Volcker Banking Crisis Plan Doesn’t Go Far Enough

Politics / Market Regulation Jan 28, 2010 - 05:30 AM GMT

By: Money_Morning

Politics

Best Financial Markets Analysis ArticleMartin Hutchinson writes: I don't often agree with the Obama administration. So I have to say that I was surprised when I heard it had a plan to reduce the risk of another banking crisis. It wants to prohibit banks that are protected by deposit insurance from engaging in risky, proprietary trading, and it wants to break up some of the very largest banks.


I made both those recommendations in my forthcoming book "Alchemists of Loss" (Wiley 2010). The book, written jointly with Kevin Dowd, a British finance professor, should debut sometime late this spring(we sent the manuscript to the publisher last weekend - what a relief!). But after I studied the Obama plan further, I realized that I shouldn't have been surprised - the idea's sponsor was former U.S. Federal Reserve Chairman Paul A. Volcker.

Politically, Volcker isn't quite my cup of tea, either. I was a young banker in New York in the early 1980s, so I saw firsthand the heroic effort he made to finally stuff inflation back in its box. I also saw - and heard - just how unpopular that effort was with many in the banking community and around the country: The whining at the weekly bank economics meetings was very shrill, indeed.

If you're Fed chairman, you like to be popular with Wall Street - as Alan Greenspan and Ben Bernanke have incessantly demonstrated. So Volcker's ability to stick to the policy he knew was right while Wall Street institutions muttered and grumbled and dragged their feet was very impressive. So it's not surprising that nearly 30 years later he's come up with a banking reform plan that I agree with.

But here's the thing: I would go even further.

There are three things wrong with modern Wall Street.

First, it wouldn't recognize good risk management if it fell across it in the Street. The "value-at-risk" (VaR) system, which most investment houses still use, is completely hopeless. It tells you that 99% of the time your losses will be less than "X." However, it completely ignores the other 1% of the potential results. Naturally, the traders got wise to its faults, and so have invented endless pathological risks that behave well 99% of the time, thus keeping VaR happy.

But that "other 1%" is quite capable of wiping out an entire continent.

Credit default dwaps (CDS) are the most notorious of the instruments that can cause such a financial wipeout, but there are others. And while 1% may not sound like much, 100 trading days is just five months, 100 10-day periods (the suggested unit) are only four years, and even 100 months is 8 1/3 years. So a system that blows apart every four or eight years is going to get damned expensive in bailout costs.

The Volcker plan wouldn't improve Wall Street's pathetic risk management capability, but it would at least quarantine the riskiest bits of the system from the parts that get deposit insurance.

The second problem with Wall Street is that the behemoths are far too big, meaning if they get in trouble they have to be rescued. There seems to be an upper limit of about $300 billion in assets, the point at which banks become unstable.

But if you look at total assets of all the banks and investment banks today, there are six above $1 trillion: Goldman Sachs Group Inc. (NYSE: GS), Morgan Stanley (NYSE: MS), JP Morgan Chase & Co. (NYSE: JPM), Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC) and Wells Fargo Co. (NYSE: WFC). Then there's a humongous gap before you get to the next two banks, PNC Financial Services (NYSE: PNC) and U.S. Bancorp (NYSE: USB), at about $300 billion.

Everything that was in between those two sizes either went bust or was absorbed by another bank in 2008. The Bear Stearns Cos., Washington Mutual, Lehman Brothers Holdings Inc. (OTC: LEHMQ), Merrill Lynch, and Wachovia all had total assets between $300 billion and $1 trillion; Countrywide Financial Corp. was just a little smaller.

Breaking the behemoths up into $300 billion chunks, as the Volcker plan suggests, would thus make the system much more stable. A Goldman Sachs slimmed down from all its hedge fund activities - with capital of $20 billion and assets of $300 billion - would still be highly profitable and could likely provide much better client service, since it would face fewer conflicts of interest.

The third, and greatest, problem with Wall Street - which the Volcker plan doesn't address - is its dominance by trading. Trading is necessary to provide liquidity, but through the explosion of derivatives and the rise of computerized "fast trading," Wall Street's operations have become "rent seeking." Trading operations scoop wealth out of the economy without giving any useful service in return. That's how Wall Street bonuses got so huge; in times of cheap money like the present, the profitability of a trading business with a substantial market share goes through the roof.

Most of those profits depend on insider information - not insider information about company activities (the use of which would be illegal) -- but insider information about trading flows (where the money's coming from and where it's going). Traders have always used this; you can't make it illegal. However, in a world where trading volume has zoomed skyward, insider information about money flows has become exceedingly valuable. What's more, unlike in most businesses, greater market share provides you with exponentially higher profits - it's more than twice as valuable to control 20% of the trading as to control 10%.

The Volcker plan does nothing about this. The best solution would be an ad valorem transactions tax, a "Tobin tax" of, say, 0.05% on every trade. This wouldn't add much cost to legitimate investing, but it would make the "fast trading," scooping a few cents per share on millions of trades a day, completely unprofitable. That in turn would return Wall Street to banking and corporate finance (arranging deals and raising capital) the businesses that actually have a value for the economy.

Still, two out of three ain't bad. Give the plan a thumbs up, and hope that the lobbyists don't succeed in killing it.

Source:http://moneymorning.com/2010/01/28/volcker-plan/

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