When I wrote my book, "Rogues of Wall Street," which reviews risk events on Wall Street around the financial crisis, it was my reasonable expectation that bankers and politicians would wish to prevent these types of events from happening again.
But in light of news that regulators are preparing to make changes to the Dodd-Frank Act’s Volcker Rule, established specifically to address many of these kinds of risks, it raises questions about whether history is getting ready to repeat itself.
The Volcker Rule, which restricts banks from speculating with depositor money, was designed to limit the types of activity that led to the 2008 crisis. The rule limits banks to trading on behalf of customers, market-making or certain forms of hedging. Bankers were also banned from investing in hedge funds and private equity funds. Under the rule, which went into force in 2015, any security held for less than 60 days is deemed a proprietary trade. As part of the rule, financial institutions have had to demonstrate to regulators that such trades are for permitted purposes.
Critics of Volcker have argued that these controls are onerous and expensive to support and have chilled banks’ ability to trade profitably and the market’s ability to function efficiently. They have cited impacts that span from reductions in market liquidity to changes in the relationship between exchange rates and interest rates. In response, the Federal Reserve announced proposed reforms to the rule earlier this month — loosening some of those restrictions and giving banks greater discretion to determine whether their trades are compliant.
But there are several reasons to be concerned with these changes.
Before Dodd-Frank, banks provided their investors and customers seemingly little protection from risky trading activity, leading to a series of sustained losses by traders who were given relatively little oversight by management. Although more details of the proposed revisions are still needed, it appears that, under them, banks would be left once again to largely police themselves.
One example: In the case of properly functioning market-making, hedging or client-facilitation trading activities, the profits per trade should theoretically be low. In such cases, a high level of profits or losses would indicate that a trader is engaging in proprietary trading, as opposed to the types of trading allowed under Volcker. When a high profit or loss is marked, under the revisions to Volcker being contemplated, it seems that bank executives would be expected to blow the whistle on themselves to the regulators and self-identify the need for more detailed assessment and self-monitoring. This sounds good in theory, however, it does not accord with recent examples of how banking executives have behaved when confronted with “excessive” profit-making in areas where such levels of profit should have given them pause. Turning a blind eye would be a better description of their behavior: the London Whale, the foreign exchange and Libor scandals, rogue trading and credit securities were all examples of this.
As for critics’ view that Volcker has had a negative impact on banks’ profitability by reducing their ability to trade and overall market activity, it is worth noting that banks have been doing quite well of late. As an example, JPMorgan Chase said that its trading revenue increased 13%, to $6.57 billion — up from $5.82 billion a year earlier. Aided by tax cuts, JPMorgan posted a record $8.71 billion in quarterly earnings leading its CEO Jamie Dimon to refer to this period as “the golden age of banking.” Other big banks posted similarly admirable profits in the last quarter. As far as market activity impacts from Volcker, there are many causes of changes in market structure, liquidity and activity, not least of them being the onset of new technology and trading strategies by market participants, as well as behavior changes among investors. Following the financial crisis, there was a huge reduction in market liquidity in mortgage securities that had nothing to do with regulators but everything to do with the unhappy results of banks’ relatively unfettered activities.
Moreover, it is an urban myth that a lack of proprietary trading has led somehow to reduced market activity and efficiency. Hedge funds have taken up the slack created by the retreat of investment banks from unsafe, exotic trading activity, and they account for massive amounts of market liquidity every day. The ranks of these hedge funds have been filled by traders from investment banks who were looking for more speculative trading environments — and their investors happily take on the risk that their investments entail. The volatility and increased market activity seen in recent months — not to mention trading desks opening up new products such as cryptocurrency — show that the heart of Wall Street is still vigorously beating. Trading in digital asset futures such as bitcoin have been offered on Wall Street since December 2017, providing new sources of income, Goldman Sachs, for instance, announced some opening moves in its digital assets trading strategy in May 2018. The level of trading generally has been up sharply in 2018 as volatility returned to the market.
Finally, investment banks have deliberately and successfully pursued more stable sources of revenue since the financial crisis. While regulators may have played a role in this evolution, so have investors. The fruits of this strategy have been the return of investor approval and healthy share price growth — for instance, Morgan Stanley’s share price has grown from $10 in November 2008, at the depths of the financial crisis, to $52 as of June 11, an increase of over fivefold. Much of that share increase has come since the introduction of Volcker in 2015, hardly an indication of financial stress and unnecessary bureaucratic burden.
Both the Volcker Rule and Dodd-Frank have been largely protecting banks from their own worst instincts over the past few years. While there are incremental reforms that can likely be made to improve the targeting of regulations like the Volcker Rule more effectively, rolling back current standards more broadly would appear to be sending the wrong signal to the country’s biggest banks and their management.