It's an economic truism that the best way to discourage undesirable behavior is to make it more expensive, and that appears to be the approach that international banking regulators are taking toward banks with large trading books.
There is little doubt that banks' exuberant leap into businesses like the securitization of subprime and commercial real estate loans over the past decade was a primary cause of the economic meltdown that the world has suffered in the past 18 months. So, regulators are erecting a big toll booth designed to make banks think twice before going down that road again.
Under new rules approved by the Basel Committee on Banking Supervision this summer, and scheduled to take effect at the end of next year, banks will be required to carry significantly more capital for many assets held on their trading books.
It will require so much more capital, in fact, that some analysts see the change as an effective reversion to an earlier era of banking regulation, when depository institutions and securities firms were strictly separated.
"I don't think it is an overstatement to say you are seeing a return to a Glass-Steagall paradigm, says Christopher Laursen, a senior consultant with the NERA Economic Consulting and the former manager of the Risk Policy & Guidance Section of the Federal Reserve Board's Supervision and Regulation Division. "Under these rules there will be some activities that require so much capital that they just aren't worth doing."
How broad an impact a significant retreat from the trading business will have, both on banks and on the broader financial markets, remains in question. Clearly, though, an increase in capital requirements will cut into banks' profits from trading - for many banks a lonely bright spot on otherwise dismal earnings reports over the past several quarters.
Should it drive some banks to exit the trading business altogether, experts say, the result could be a loss of liquidity at a time when the economy can ill afford it.
The new rules are meant to bring the capital charges for assets held on a bank's trading book in line with the charges for similar assets held in the banking book.
"Nobody is questioning that the new rules mean at least a doubling or tripling of the capital banks currently hold against their trading books," says Andres Portilla, deputy director of the Institute of International Finance, a trade group representing international financial institutions.
For some banks, the increase could be even more significant. The Basel Committee polled 43 international banks earlier this year, asking them to estimate the effect that the new rule would have on their trading book capital.
The average increase in trading book capital was 223.7 percent, but the variation between banks was enormous, with one unidentified institution reporting that its trading book capital increased 1,112.8 percent.
Numbers like that, experts say means that banks will either begin to migrate out of the trading business or scale way back.
"For banks that are in a capital constraint situation, the trading book is one of the first areas where they can see a significant decrease in capital requirements if they reduce their activity in that business," says Portilla. "It will vary across institutions, but for some banks it will definitely mean a reduction in their trading activity."
In the U.S., the new rules are expected to apply mainly to large banks that are already subject to the Basel Committee's market risk amendment. In general, that means that banks with trading assets equal to 10 percent of total assets, or more than $1 billion in trading assets.
Experts are not certain of the number of banks that the new rules will capture, but point out that even if it is a relatively small fraction of the thousands of banks in the U.S., it will encompass the vast majority of banks with significant trading operations.
While nobody is calling for banks to dive back into complex subprime securitizations the way they did in the middle part of this decade, some experts caution that by making it much more expensive to buy and sell certain securities, the new rules may have a more profound effect than regulators expect - or want.
The new rule "ratchets down the complexity" of banks' involvement in securitization, warns NERA's Laursen. "But there is a natural financial reason to have tranched commercial real estate bonds."
The new rules, by raising capital requirements to the point where making a market in certain securities is no longer profitable, could limit securitization overall by sharply reducing liquidity. "You don't want to be in a position where a firm can't make a market in the simple securities we want markets in," says Laursen.
