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Sunday, May 16, 2010

Is Merkley-Levin "A Joke"?

Economics of Contempt argues that statutes that ban on proprietary trading at banks and bank holding companies must leave considerable discretionary power to regulators, attempts to be more specific end up creating more loopholes than they close:

Merkley-Levin Is a Joke, by Economics of Contempt: The Merkley-Levin Amendment (SA 3931) is a version of the Volcker Rule. The Volcker Rule, if you'll recall, is a ban on proprietary trading at banks and bank holding companies (BHCs). If you ask Merkley and Levin's offices, they'd no doubt tell you that their amendment significantly strengthens the existing Volcker Rule language in the Dodd bill (Section 619 of S.3712). Don't be fooled — it does nothing of the sort. I spent the majority of my career as a lawyer for a big investment bank, and my first thought after reading Merkley-Levin was: "Wow, this would be cake to get around." Wall Street is scared of the Volcker Rule, but believe me, they're not scared of Merkley-Levin.

This requires a bit of explanation. To ban prop trading at BHCs, the law must distinguish between market-making trades and propietary trades. Market-makers stand ready and willing to buy or sell securities for their own account, at firm bid and offer prices. If an investor is looking to sell a security, the market-maker will buy the security using its own capital, and hold it in inventory until an investor who's looking to buy the security surfaces. Holding many inventories of securities (i.e., bonds, stocks, derivatives) exposes market-makers to all manner of short-term market risk, interest rate risk, foreign exchange risk, etc. This requires market-makers to do quite a bit of hedging in order to safely carry these inventories. We don't want to prevent banks from hedging the inventories they hold as market-makers, but we do want to prevent banks from entering into trades that aren't intended to hedge a risk associated with its market-making activities — that is, purely speculative prop trades. This is a difficult and complicated task, but it can be done (I've seen it done from the inside).

Ideally, what the financial reform bill would do is just say, "Proprietary trades are banned; market-making trades are allowed," and then let the regulators work out how to define "market-making trades" and "proprietary trades." This is something that simply can't be done at the statutory level; it has to be done at the regulatory level. Unfortunately, these days it's fashionable for people to bash any sort of regulatory discretion as tantamount to letting Wall Street win. This is where Merkley-Levin comes in, because it's clearly a response to this "anti-regulatory discretion" meme. ...

Merkley-Levin prohibits "proprietary trading," which it defines very broadly, and then creates 9 categories of "permitted activities" (listed in section (d)(1) of the amendment). The categories of "permitted activities," which function like exceptions to the definition of "proprietary trading," are so ridiculously broad that they completely swallow the amendment's prop trading ban. ...[goes on to lists several exceptions and then explains why they are problematic, for example]...

...So essentially, section (G) allows BHCs to continue their prop trading through their London offices, provided they find non-US counterparties (shouldn't be too difficult), and the trading isn't being controlled by someone in New York (fine, just send all your prop traders to London). And this is in addition to all the prop trading the banks could do out of their New York offices under the ridiculously broad "permitted activities" in sections (d)(1)(B) and (C). Seriously, this would be like taking candy from a baby for the dealer banks. ...

People often ask why I say that complicated financial regulations can't be written at the statutory level. The reason, sorry to say — which Merkley-Levin demonstrates quite well — is that Congress sucks at writing complicated financial regulations.

I think specific rules are best, where they can be applied, but strict dividing lines aren't always possible and regulators will generally have at least some discretionary power in enforcing the rules. In addition, even with very specific rules, it still comes down to the will of regulators to enforce the statutes on the books. Strict rules don't do much good if the people enforcing them simply look the other way when they are violated. But I don't know enough about this particular issue to say whether strict rules on proprietary trading are as difficult to write as described above. The argument sounds convincing, but an experienced lawyer ought to be able to make a convincing case. Anyone want to argue the other side?

One other note. If discretionary authority for regulators cannot be avoided, and it can't, and if it sometimes involves very important, but complicated issues, as it does, then we need qualified, dedicated regulators. We are seeing the consequences of poor regulation in the gulf right now, and those problems, together with the problems that poor regulation caused related to the financial crisis, show that the consequences of lax regulation, regulatory error, or poorly structured rules and regulations can be very, very large.

We have been through a period where the people in charge of regulation were not chosen with much care. The attitude toward government in the previous administration led to these positions being used as rewards for political support or to further the administration's ideological agenda much more so than before, and this administration has not moved as fast as it should have to clean up the mess. I hope that recent events lead people to better understand the importance of filling the agencies in charge of regulation with dedicated, capable people, and that politicians and administrations that do not take this mission seriously will be held accountable. But I hope for lots of things, it certainly doesn't mean they'll happen. However, I am encouraged by recent indications concerning financial reform regulation. It's not as strong as I'd like, but it's looking to be much stronger than I thought it would be, so perhaps there's hope that we are beginning to take these issues more seriously than we have for some time now.

    Posted by on Sunday, May 16, 2010 at 06:57 PM in Economics, Financial System, Regulation | Permalink  Comments (3)

          


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