17/02/2010 Author: Christopher Miller

Comment: Christopher Miller

Where did President Obama’s ‘Volcker Rule’ suddenly come from? Like much of the banking and hedge fund regulation recommendations emerging from G20, de Larosière etc, the origins are in a document that was quietly published in January 2009, by a think tank comprised of a group of former international leaders led by Paul Volcker, known as the Group of Thirty.  And, like EU measures on alternative funds, at each step, the language has been strengthened. It’s a bit like gold plating a gilded lily.

The issues raised are not just those of “particularly high risk” in banking; they are about “serious conflicts of interest”. Paul Volcker has clear doubts about the integrity of Chinese walls within banks. He thinks that it is worth addressing these as well: why waste a good crisis?

Reactions have been mixed. A senior figure in the UK government told me that “...no one can see how you can separate the prop trading from customer activities.” But the threat is certainly having an impact, as banking staff not directly involved in “narrow banking” are rushing to the non-bank financial sector in anticipation that banks will be forced to lay them off.

My views are based on the time I was a banking analyst some years ago. I learned then that one of the basics of managing banks is that diversified fee-earning activities make banks more stable. The Rule bundles up a host of such activities with prop trading, and outlaws banks from those businesses. For the record, the original wording from Volcker’s report included: “Sponsorship and management of commingled private pools of capital (that is, hedge and private equity funds in which the banking institutions own capital is commingled with client funds) should ordinarily be prohibited and large proprietary trading should be limited by strict capital and liquidity requirements.”

As well as prop trading, it seems that areas at risk will also include prime brokerage, administration; and paradoxically, management of hedge funds if the bank has invested parri passu with clients. This last point is important because for investors, the conflict of interest is actually reduced if a manager has aligned interests.

Whatever one’s views on prop trading, it’s simply nonsense to rule out stable diversified fee-based revenue streams for banks, such as services to hedge funds. While today, banks are clearly too big, the opposite is no better. The solution lies somewhere in between. Perhaps a return to the UK banking system of the 19th and early 20th centuries, where banks were smaller and had diversification, but crucially, they specialised in different areas, which lowered systemic risk.

The point about separating prop trading from customer activity is well made, but the original text said that “large proprietary trading” should be “limited”. It did not say “stopped”.

If they do the job properly, I think the ultimate solution for banks will be:  
•    To sharply limit the amount of risk that can be taken as part of market making, customer or prop trading activity, without attempting to differentiate between them;
•    allow ownership of alternative managers and co-investment in funds subject to the above;
•    allow hedge fund services;
•    but not flagrant proprietary trading dwarfing the banking activities;
•    and leverage exposure to hedge funds will be constrained further.

This may mean that certain investment banks will have to come clean and declare themselves to be hedge funds, not banks. There will hopefully be demergers instead of fire sales, or shutdowns.

I personally don’t think most of Volcker’s measures are necessary or advisable, given the disruption they would cause. I’m hardly a banking cheerleader, but I think most of the problems arose when the SEC ill-advisedly relaxed leverage requirements for investment banks in 2004.

Leverage promptly rose from not much more than 10x to over 30x in investment banks, at a time when banks were being explicitly told through the US National Homeownership Strategy to help out poorer people by making it easier for them to get onto the housing ladder. This reminds me of the hasty deregulation that contributed to the savings and loan disaster. There’s no doubt that the banks were eager helpers handing out loans in a rising property market, so by all means punish them; I just don’t see the need to change things that aren’t broken.

Ultimately, it will be simply a question of negotiation between Obama and Goldmans, and how popular the moves are in the press

Christopher Miller is CEO of Allenbridge Hedgelnfo, a hedge fund consultancy firm; and these are his personal opinions.