In September 2008, within a few weeks of the fall of the house of Lehman, I had written the following, excerpted from my research note titled, “The Future of Investment Banking: Subprime and what it Means for The Industry.”A New Glass Steagall
As investment banks are consolidated into commercial banks and the fixed income businesses look to tap into the lower cost of funding associated with deposits and commercial banking endeavors, I also would not be surprised if we get a new Glass Steagall-type of legislation which will again draw the lines between investment and commercial banks.
While Glass Steagall mostly split investment and commercial banking across equity/corporate underwriting (investment banking only) and fixed income (both investment and commercial banking) lines, most if not all of the challenges stemming from the subprime crisis occurred on the commercial banking side. It was not the equity side of the business that blew-up; it was the fixed income side, which has historically been thought of as the safer side. I don’t think that the government would split out the mortgage or the loan business from the commercial banking side; however, besides better managing the amount of leverage implemented on commercial banks, I could easily see that various risk-type businesses being split from these US Universal Banks.
This may mean that while these new Universal Banks have both equity and fixed income businesses, that the Universal Banks would be prohibited from proprietary trading, taking sizeable risk positions, and or underwriting corporate securities (both equity and corporate debt), leaving the Universal Banks’ role in capital market as more of a processor, custodian, and agency trading operation rather than engaging in proprietary trading capitalized by deposits, and naïve investor capital.
While I assume that President Obama and Paul Volker didn’t read this, I believe that the direction is sound. Why are we allowing depository institutions to leverage inexpensive and taxpayer-guarantee funding to take proprietary risks where both the shareholder and by default the taxpayer bear the risk?
Now that said, implementing a policy like this will be extremely difficult. The banks, of course, will fight it but even ignoring the fight – how do you practically implement this type of strategy and even if you do, how will this impact the global financial markets?
Defining Prop Trading
Defining proprietary trading will be next to impossible. Investment banks take risks and separating the proprietary risks from market-making risks or client-servicing risks will be difficult. While there are people within the banks with proprietary trading roles, many of the positions held by the proprietary traders would be virtually indistinguishable, from an outside perspective, from market-making / customer-facilitation positions. For example, how would the regulators distinguish the following positions?
- First, the bank sees an opportunity to buy $50 million of undervalued US auto debt, and
- Second, a large mutual fund wants to unload $50 million in US auto industry debt and the bank offers to execute the trade using its own capital to facilitate the trade
While the first example is clearly a proprietary position and the second is not, how would a regulator distinguish between these two positions? In both cases, the firms has built up a position in US auto debt. In both cases the amount is $50 million. The positions from an auditor’s perspective would look identical. Today, these positions are differentiated by the trading accounts in which they are housed. While this is good for accounting purposes, I am not sure this will pass muster with regulators.
So how do you ensure that firms do not take proprietary positions? Do you require that the bonds be bought directly from a customer? If so, how do you police it? Proprietary positions don’t need to be acquired only via inter-dealer brokers. Do you require a recording of the client conversation? Do you just fire the proprietary traders? Do you segregate proprietary and customer-facilitation positions by a holding period test? What if you can’t find the other side of the trade? Do you force the bank to sell the products at a loss? Do you force the bank to only act in an agency position? If you do this, then the bank would need to either increase its sales force dramatically or lower the price of the bonds to attract an immediate counterparty. I am not sure issuers, or investors, would care for either solution.
If we look to tease proprietary trading from customer facilitation and market making by holding period, many firms have a proprietary, high-frequency, equity / options / futures trading business. These businesses take very short term positions looking for liquidity gaps. While many firms call this proprietary trading, much of this can also be called market making. What is the difference?
Will we be able to tell what is proprietary from market making by the portfolio/trading account they are traded out of? I am not sure that will be effective.
Properly defining the difference between market making, customer facilitation and proprietary trading is critical. If the government makes it too difficult for banks to take positions, then there will be less liquidity in the market, meaning fewer buyers and sellers, wider spreads, and greater costs not only to trade but for companies, and for that matter. governments to raise capital.
The impact of this across asset class will be significant. Products that employ less capital will be less impacted. Exchange-traded products such as equities, options and futures will have little impact since these products are for the most part traded “as agency” (meaning the banks don’t take big positions in these markets – except to hedge other less-liquid positions) and the risk-taking functions within these asset classes have effectively migrated from banks to other market participants such as high frequency traders. So if regulators could tease apart proprietary trading from market making and customer facilitation and banks eliminated their proprietary trading, market liquidity may change somewhat over the short-term but other players will quickly and easily fill in the gaps.