TWN Info Service on Finance and Development (Mar10/01)
10 March 2010
Third World Network

The real price of proprietary trading
Published in SUNS #6876 dated 4 March 2010

Geneva, 3 Mar (Chakravarthi Raghavan) -- Proprietary trading, properly defined and contextualised, has had a great deal to do with the current financial crisis, and moves for financial and regulatory reforms, the so-called "Volcker Rule" endorsed by US President Barack Obama, need to be beefed up considerably and broadened to include investment banks, hedge funds and other corners of the financial world.

This view is in a "Safer" Policy Note #15 dated 18 February, authored by US academics James Crotty, Gerald Epstein and Iren Levina of the Political Economy Research Institute (PERI), University of Massachusetts, Amherst. SAFER (Economists' Committee for Stable, Accountable, Fair and Efficient Financial Reform) is a project of PERI of the University of Massachusetts.

[Meanwhile, latest media reports from Washington suggest that the outlook is for a financial reform legislation with no more than cosmetic changes that would enable the financial players and traders to continue with business as usual - until at least the next bigger crisis that this would engender. This outcome is being attributed to the regulatory capture of the reform process in Washington, and the Republican (and conservative Democrats') opposition to any fundamental reforms. The US House of Representatives has adopted a bill with some teeth, but the US Senate (where the Republicans can deny the 60 votes needed for filibuster-proof enactment) is yet to adopt a financial reform bill, which thereafter needs to be reconciled with the one adopted by the US House of Representatives.

[The final outcome is now foreseen to be no more than some cosmetic changes that would enable Wall Street and the big global financial firms, which contribute heavily to Congressional elections and have now been enabled to finance targeted campaigns against Congressmen and Senators favouring regulations and reining in of the finance sector, not only to continue their current models, but with some assistance from the World Trade Organization and its Trade in Financial Services rules and to liberalisation drives, to engulf the developing world (which escaped the recent financial meltdown, but not its economic consequences) in a worse crisis.

[The outlook in Washington has provoked Nobel Laureate and New York Times columnist, Mr. Paul Krugman, to suggest that it would be better to have no financial reform than a bad or weakened reform bill. This view is also endorsed by James Kwak at a post on The Baseline Scenario, where Simon Johnson, a former chief economist of the International Monetary Fund, in testimony before the US Congress, has taken a similarly critical view of Wall Street shenanigans that brought about the financial crisis, and the inadequacies of the Volcker Rule.

[Meanwhile, in another post at Baseline Scenario, Simon Johnson notes that the Dodd-Corker financial reform proposals due to be unveiled in the US Senate, while it may have some impact on "relatively small players" in the US, will not rein in any way the big banks. The proposed resolution authority/modified bankruptcy procedure under discussion would do nothing to make it easier to manage the failure of a financial institution with large cross-border assets and liabilities. For this, one would need a "cross-border resolution authority," determining who is in charge of winding up what - and using which cash - when a global bank fails. While such an authority could be developed under the auspices of the G20, there are not even baby steps in that direction.

[According to Johnson, hopes that banks could be constrained through some form of international governmental cooperation is a complete illusion. The IMF and the WTO have no mandate on this issue. The Financial Stability Board is a paper tiger - really just a talking shop between regulators, and the same goes for the Bank for International Settlements more generally. The big global banks know all this - and have known it for years. When Jerry Corrigan - former head of the New York Fed, no less - says Goldman did "nothing inappropriate" in arranging Greek debt swaps, he is in effect saying "catch us if you can".

[The international banks cannot be stopped at the international level, but need to be curtailed at the national level. And one can't afford to wait for other countries; but do it for your own country as a matter of pressing national priority. Unfortunately, the Dodd-Corker proposals seem most unlikely to move us forward along this dimension, he said.]

The three PERI academics note that President Obama's endorsement of the "Volcker Rule" has produced an intense chorus of responses from bankers, economists and policy-makers.

The "Volcker Rule" broadly encompasses a set of proposals designed to reduce public financial support for risky proprietary trading and hedge/private equity fund ownership by commercial banks and bank holding companies.

The critics of the proposed "Volcker Rule", the Safer brief notes, have made three main claims. First, proprietary trading had little to do with the current financial crisis and therefore restricting it would do little to prevent a replay; and second, proprietary trading provides a very small percentage of bank revenues and therefore is not significant.

The implication of these two points is that it is not really worth the political battle to restrict proprietary trading because it is small and unimportant.

A third set of criticism (by many bloggers, economists and some financial analysts), is that the very narrow limits of the Volcker Rule would make it easy for bankers to evade the restrictions, and would allow investment banks and others in the shadow financial world to undertake many risky and dangerous activities that could crash the system and require taxpayer bailouts.

This implies that the Volcker Rule would have to be beefed up considerably and broadened to include investment banks, hedge funds and other corners of the financial world in order to reduce the risk in the system to acceptable levels and to significantly reduce the likelihood of the need for future massive taxpayer bailouts.

The three academics argue in their brief that conventional banker wisdom (of the small role of proprietary trading in the crisis) is incorrect.

"Proprietary trading had a great deal to do with the crisis and it also contributes significantly to major bank revenue." However, critics are right to argue that the Volcker rule has to be strengthened and broadened, specifically to large investment banks and the shadow banking system, in order to significantly reduce the risk in the system to acceptable levels and to limit the likelihood of the need for future taxpayer bailouts.

The Safer brief argues that given the objective of the "Volcker Rule", the term "proprietary trading" is a misnomer. Risky proprietary investments by investment banks, along with trading for clients whose decisions were influenced by these banks, was one of the main forces that sustained upward pressure on security prices in the bubble. Indeed, by running large trading books, banks had inside information on client trading patterns and could use that information to front-run, and thereby help sustain market trends.

Banks, the Safer brief points out, maintain large inventories of the securities ostensibly to facilitate trading, but these inventories in fact include substantial quantities of proprietary investments hidden within market-maker inventories. By 2008, bank trading books held hundreds of billions of disguised proprietary investments.

By mid-April of 2008, banks had lost roughly $230 billion on their super-senior CDO (collateralized debt obligations) proprietary holdings that regulators and other interested parties believed were simply inventories of assets held to facilitate client trading. These losses were probably created from about three quarters of a trillion dollars worth of risky assets. Clearly, proprietary trading was a major cause of the recent crisis.

Despite these massive losses, within a day or two of the Volcker Rule announcement, the press was full of stories quoting data from bank analysts that proprietary trading was very small. The Safer brief says there is strong evidence that these widely cited numbers are much too low. A closer look at the data suggests where the low-ball estimates may be coming from. It also provides a good benchmark to provide estimates of the size of this activity on banks' revenues.

Firstly, the widely reported data are likely to have been taken from the crisis years, 2008 or 2009, rather than from the period during the height of the bubble years. But if one is trying to assess the impact of strict rules in preventing future problems, surely, the pre-crisis years are more relevant.

Second, the quoted shares are of gross revenue rather than net revenue. Gross revenue is, of course, a much bigger number and therefore will reduce the size of the ratio. Net revenue is a much more relevant figure because it is that which is divided into salaries, bonuses and profits. It is a much better measure of the bottom line. If one looks at the ratio of trading income as a share of net revenue, while it was 5.1 % in the year of the crash, it was more than 45% at the height of the boom in 2006.

Third, the widely cited estimates are almost certainly trying to estimate proprietary trading in the most narrow way possible (trading for own account) and likely do not take into account the often arbitrary lines that are drawn between own account, client account and market making aspects of trading, position taking and investment.

In the Safer brief, the three academics have carried out some rough calculations of trading for three banks: Goldman Sachs, Morgan Stanley and Citigroup. These estimates must be seen as very rough because the data is so difficult to break down, but "we believe they illustrate our points."

First, Morgan Stanley's data shows that in 2008, when the system crashed, its trading and investment revenues were about 2% of total revenue. Though it may not be precisely "proprietary trading" as defined narrowly, the fact that this figure was so widely cited by bank analysts does suggest that "our data is in line with quoted estimates". But in 2006, at the height of the bubble, trading income as a share of total revenue was more than 19%.

Similarly, for Goldman Sachs, in 2008, trading income as a share of gross revenue was reported in the media to be around 10% and according to the calculations of the academics, about 15%. But if one goes back to the boom years of 2006, it was more than a third of the gross revenue, almost 35%. As a percentage of net revenue, trading income was much higher, 36% in 2008; in 2006 and 2007, it was a whopping 64% or more of net revenue.

For Citigroup, the numbers are even rougher than for Morgan Stanley and Goldman, but they tell an interesting tale. Trading and investment revenue as a share of gross revenue in 2006, at the height of the bubble, was only about 5% of gross revenue, the number cited by many in the press. If one uses the more appropriate net revenue figure, then this share jumps to over 9%.

Interestingly, if one looks at the contributions to Citigroup's revenue losses during the crash, according to these admittedly crude estimates, trading and principal investments played a significant role. In 2008, for example, trading and principal investment losses amounted to 20% of gross revenue and over 40% of net revenue. If one counts these trading losses as a percentage of the declines of total and net revenue, these numbers become much higher.

For example, between 2007 and 2008, Citigroup's total revenues fell by almost $50 billion and net revenues fell by almost $26 billion. In 2008, Citigroup lost $22 billion, which amounts to 44% of total revenue losses and more than 80% of net revenue losses.

Contrary to the bankers and pundits that claim that "proprietary trading" did not cause the crisis, these losses led to a taxpayer bailout and constitute, in fact, one of the main components of what most of us mean by "the financial crisis."

In this light, the academics advocate in the Safer brief that:

1. The Volcker Rule must utilize a broad definition of proprietary trading, investment and position taking if it is going to succeed. Trading and proprietary investments made a much bigger contribution to bank revenues (and losses) than bankers and the press have suggested. It is virtually impossible to distinguish proprietary trading and investments from market making and trading for clients, which often involve proprietary investments and position taking by the banks. Trying to make highly restrictive definitions of proprietary trading will make it very easy for banks to use accounting gimmicks to move investments, position taking and proprietary income to where it is not restricted by the rule.

2. The Volcker Rule must be expanded to significantly help reduce systemic danger. Most important is to expand restrictions to investment banks, as well as to the "shadow" banking and financial world.

3. There needs to be a revolution in accounting standards and reporting. Regulators and the public do not have adequate information on the quantity and quality of these investments. Accounting standards and reporting requirements need to be complemented by close, hands-on financial examination by regulators. Without this, banks will be able to manipulate trading, investments and positions around virtually any set of rules that are created.

(A detailed version of the Safer brief, with references and notes, can be found at www. peri. umass. edu/safer.) +