Bank regulatory reform is heading toward misguided re-engineering as legislators seek the wrong answers to the wrong questions. Both the highly publicized Volcker Rule and a more obscure proposal to treat intercompany swap transactions as credit exposure are examples of misplaced concerns.

Confining bank trading activity to hedging, market making or customer facilitation — or to further restrict derivative transactions whose purposes may fall within those categories — does not address the fundamental problems of our banking system.

To the contrary, proprietary trading by banks and the consolidated management of derivative risks are well-established practices that have functioned successfully. Under the statute that gave birth to the national bank system, a core function of national banks was to distribute federally issued currency secured by the banks' purchase of federally issued debt. The resulting legislative scheme led national banks to engage in proprietary trading in currency and federal debt markets. Over the years, this role expanded to embrace trading of a broader array of financial instruments — including derivatives — across entities within banking institutions.

In contrast to the Volcker Rule and proposed changes to Section 23(a) of the Federal Reserve Act, the resulting regulatory approach does not arbitrarily proscribe segments of market engagement. Instead, limitations were developed to ensure trading activities are conducted in a manner consistent with "prudent banking practices."

For decades, this approach worked. Banks played an integral role in permitted proprietary trading. New products were added to the scope of permissible trading activities, subject to safety and soundness requirements.

By virtue of processes required to engage in these activities — although arcane and cumbersome to some critics — banks engaged regulators in ongoing dialogue that fostered successful product development and viable trading functions.

Although there are shortcomings that led to critical problems, proprietary trading and intercompany derivative transactions, per se, were not the causes. The bulk of the losses incurred by banks arose from mortgage-backed securities and exposure to monoline insurance companies providing credit support for MBS transactions. Though banks traded MBS and used derivatives in transactions with problematic counterparties, we are better served by asking what made these specific products, transaction types, markets and participants unsafe and unsound than by redirecting the blame more generally.

We are also better served by asking why problematic businesses developed under a previously successful regulatory model for product development. Some have pointed the finger at the expanded powers in Gramm-Leach-Bliley, but I would argue that the primary source of weakness was the regulatory framework created to manage the resulting activities. "Functional regulation" created supervisory silos that were not capable of managing increasingly complex transactions with increasingly integrated products, markets and participants. Further, as approval processes were altered or eliminated, the dialogue between regulators and banks diminished. Rather than limiting productive activities, we should be asking how to manage relationships among regulators, market participants and markets to restore successful results.

Regulators must have adequate information to make market activity transparent, the correct set of tools to intervene in interconnected markets, and the ability to act in a coordinated manner and engage an adequate range of market participants to address developments.

Banks need to do their part. Though the industry has taken some important strides to engage in constructive dialogue with regulators — such as recent initiatives designed to diminish counterparty risk and increase transparency in derivatives — the industry must make it clear that it is prepared to restore full meaning to the term "prudent banking practices."

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