The Fallacy Of The Volcker Rule (Or "Fixing" The Banks In 5 Easy Steps)
Submitted by Peter Tchir of TF Market Advisors,
Volcker Rule - Who cares? I know we are supposed to care more about this convoluted rule, but we just can’t.
The concept that somehow “prop” trading brought down the banks seems silly. The idea that market making desks were a dangerous part of the equation is ludicrous.
They could have fixed this with a few simple changes, but that would have meant some blame would have had to be shifted onto the regulators...
The inability of regulators to communicate and create consistent rules had more of an impact than anything else. The single biggest problem was that the insurance rules and bank rules did not line up. Banks could load up on AAA tranches of ABS CDO’s (including sub-prime) and buy protection for companies that could never hope to pay it off if it went wrong and attract almost no regulatory capital. The entity that sold it would run some actuarial models and also have no regulatory capital. At some point the regulators allowed some AAA risk, which should have attracted significant capital, to attract none. Making the insurance regulators and bank regulators communicate and close loopholes would be a simpler and more effective solution than Volcker.
The rest could be fixed by a few simple hires.
First, hire a junior person from the risk management side of any mediocre hedge fund. They would immediately want to put in place some limits on gross notionals. Yes, hedging and relative value is potentially profitable, but you still want to limit the size. That would reduce curve trades, the unnecessary proliferation of back to back derivative trades, etc. It would help ensure that the “worst case” isn’t so bad or so convoluted that investors get too nervous.
Second, hire a junior level accountant. They could quickly realize that when some massive percentage of the P&L is driven by model risk (correlation trading for example) you should be nervous. Limit the amount of risk offset that can be derived from models and do the same with P&L. It is great that banks can use their models for capital requirements and to a large degree it makes sense, but models are notoriously wrong – sometimes by accident, sometimes because no one knows better, and sometimes on purpose. Don’t eliminate the use of models, but keep it to a size that is reasonable.
Third, hire someone from the IRS. Make a “progressive” capital system. Charge more as the size of a position increases. Owning $25 million, $100 million and $250 million of the bond is not usually linear. In most cases owning $250 million is more than 10 times riskier than owning just $25 million. This applies to individual holdings and a portfolio. Too big to fail would yelp but that is the reality and would be much simpler than what we got.
Fourth, hire a retired mid-level commercial banker from the 80’s. They can remind everyone that lending is risky and that banks have blown up in the past based on dumb loans, no mark to market accounting, and inadequate reserves. Banks don’t need these newfangled inventions to blow themselves up – they were capable of blowing themselves up in the exact sort of environment Volcker seems intent on dragging them back into.
Five, fire 1,250 lawyers. The ratio of lawyers to people who know their way around trading or risk is absurd.
In the end, banks are taking less risk because they don’t want to. If and when they want to, they can probably find a way. The Volcker rule is overly complex. Banks will shy away from activities for now. That is probably bad for bank stocks at the margin but remains good for bank credit as tail risk is pushed off (at least until they get bloated on bad loans, but that is years away).
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