Should banks be allowed to conduct proprietary trading operations? That sounds like one of those arcane issues in financial regulation that is incomprehensible to ordinary people. But it isn't, and ordinary people should regard it as a matter of utmost importance to themselves and make their concerns clear to their representatives. "Trading" is a clear enough term. It means buying and selling on the market - in this context, buying and selling financial instruments on the financial markets. These "instruments" include everything from simple government bonds and shares of companies, to currencies, commodities and the panoply of increasingly complex constructions that are covered by the catch-all headline of "derivatives." Trading is dangerous, in that you can lose as well as win.But if you are a professional trader, working in a large financial institution and backed by an awesome array of computerized wizardry, expert research and layers of oversight and controls, you should win far more often than you lose. That is what actually happens. Big banks and other institutions, trading for their own accounts - that's what "proprietary" means - generally make hefty profits from this activity. Nowadays, when banks have little interest in boring things like lending money to companies, they need their trading profits more than ever and certainly don't want that business made illegal. However, the bank's depositors, as well as taxpayers, should see things very differently. True, by and large banks make profits from their proprietary trading. However, when they lose, they lose very big - sometimes big enough to sink the entire institution. When this happens, it somehow always turns out to be a "rogue trader" who was responsible for the mishap - like Nick Leeson , who single-handedly gutted the British merchant bank Barings in the mid-1990s. But these "rogue traders" are an intrinsic part of a culture of risk-taking. They are incentivized to make large bets by a remuneration system that gives them a hefty chunk of their winnings in the form of bonuses, while not penalizing them when they lose money (other than being fired, upon which they merely move to another, similar institution). Because so large a proportion of many banks' profits comes from trading, the bonuses and overall standing of senior management, not to mention the dividends of shareholders, are also tied to these operations. In other words, proprietary trading generates an extreme form of moral hazard: There is a strong personal and institutional incentive to engage in it and encourage it - and very little disincentive. Furthermore, it is normal to use leverage in trading; i.e., to borrow money to increase the size of the bets taken. When this works, the returns on capital are enormous. But when it goes wrong, the results can be disastrous. All this has long been known and was amply demonstrated in the period preceding the crash of 2007-08, when, it will be recalled, several large investment banks collapsed and several of the largest banks had to be bailed out, supposedly to prevent the entire financial system from collapsing. The bailouts in the US, UK , Switzerland and elsewhere triggered great public anger and demands for sweeping reforms. Meanwhile, it should be added, our knowledge of bank proprietary operations has broadened. We now know that the world's biggest banks connived together to rig the prices in key financial markets: the interest-rate market, via the Libor rate that they were allowed to fix among themselves, parts of the bond market and various others as well. In the US, the demand for a cleanup of the financial system gave rise to the Dodd-Frank reform. This threat spurred the banks to an unprecedented effort, via their lobbyists and supportive politicians, to derail, dilute or otherwise deal with the reform proposals. The result was a gigantic law of almost impenetrable complexity, which, three years after its passage, is still being fleshed out by even more voluminous secondary legislation. A central element of the overall reform, known as "the Volcker rule," sought to prevent the banks engaging in proprietary trading. This ought to be simple enough to enact; you just say they can't trade on their own account. Israel made this change after its banking collapse in 1983, and the banks have been banned ever since from proprietary trading in equities and derivatives. When Paul Volcker , the former chairman of the Fed, proposed his rule, he did so in one paragraph. That's all you should need, if you are serious. In America, however, nothing is simple, and the lawyers and lobbyists had a field day with the Volcker rule. Last week, the five regulatory bodies that oversee the banking and securities sectors in America finally approved the regulations implementing it. But that demanded 100-odd pages defining what it does and doesn't apply to, when and how, as well as hundreds more pages of supporting material. The story of the Volcker rule and its implementation and emasculation is a case study in who really runs America and whose interests the legislators truly represent and look after. www.pinchaslandau.com (c) Copyright Jerusalem Post . All rights reserved.
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