In his interview in Der Spiegel, Paul Volcker argues that banks must not be allowed to take on proprietary risk except for risk incidental to "client activities". Quoting from the interview:

"SPIEGEL: Banking should become boring again?

Volcker: Banking will never be boring. Banking is a risky business. They are going to have plenty of activity. They can do underwriting. They can do securitization. They can do a lot of lending. They can do merger and acquisition advice. They can do investment management. These are all client activities. What I don't want them doing is piling on top of that risky capital market business. That also leads to conflicts of interest."

This is a more nuanced version of the argument that calls for the reinstatement of the Glass-Steagall Act. But it suffers from two fatal flaws:

  • Regulatory Arbitrage: Separation of "client risk" and "proprietary risk" sounds good in theory but it's almost impossible to enforce in practise. As I've discussed previously, a detailed and fine-tuned regulatory policy will be easy to arbitrage and a blunt policy will result in a grossly inefficient financial system.
  • Losses on "Client Activities" were the major driver in the current crisis. My analysis of the UBS shareholder report highlighted how the accumulation of super-senior CDO tranches was justified primarily by their perceived importance in facilitating the sale of fee-generating junior tranches to clients. It is the losses on these tranches issued in the name of facilitating client business that were at the core of the crisis. It is these tranches that caused the majority of the losses on banks' balance sheets. It is losses on insuring these tranches that brought down AIG. Segregated proprietary risk is monitored closely by almost all banks. The real villain of the piece was proprietary risk taken on under the cover of facilitating client business.

Comments

Tango

The financial sector financing the risky (client) activity is like owning debt in it – the maximum upside is limited while the maximum downside is 100%. The sector engaging itself in the same risky activity (proprietary business) has potentially unlimited upside/downside. At a systemic level it is immaterial who owns that risk. Let us assume (i) the general amount of risk taking in the system is a function of available leverage and opportunities; (ii) is independent of the existence of likes of Glass–Steagall Act and (iii) no firms/banks are bailed out. In such a scenario whenever the loss at a risk taking venture (bank or not) exceeds the equity available, the extra loss is borne by the system (not the taxpayer in this case). Now if one category of creditors (e.g. small deposit holders) needs to be protected from this – they need to pay a premium for it and swap the counterparty risk of the bank by the sovereign risk. Glass–Steagall or not, until you don’t rid the system of bailout mentality there will be remain inefficiencies and asymmetric payoffs (profit privatisation & loss socialisation).