Thursday, January 21, 2010

Shrinking Banks - Ari Paul

Today, Obama announced two new initiatives to dramatically reduce the size of large banks and the risk they take. Depending on how these are implemented, it could be revolutionary, cataclysmic, or business as usual.

The long delayed political populism is gaining momentum. Obama asserts that he will “recover every last dime” that was paid to large financial institutions. He says he will “no longer allow banks to stray too far from their central mission of serving their customers.” To accomplish this he is proposing the new “Volcker Rule”, which will ban hedge fund and private equity operations by large banks. Secondly, Obama is planning to extend the deposit cap to include other forms of bank funding, effectively limiting the size of big banks and preventing further consolidation.

The first thing to note is that the 50 largest banks provide about 85% of all market liquidity. If they completely stopped trading tomorrow, equity and bond trading would basically cease. The fear of this scenario could drive violent liquidations as asset managers rush to avoid a repeat of October 2008, when they couldn’t find a bid to sell their bonds and derivatives.

Realistically, I think these new initiatives are unlikely to have a huge impact. Obama has said that banks will still be allowed to execute customer orders. In doing so, banks frequently take the other side of the trade. This is conceptually prop trading since the bank is exposed to loss and may use skill to produce gains. However, it is considered market making within the financial community. The CEO of Goldman Sachs, Lloyd Blankfein, recently told the Senate that Goldman Sachs did not engage in prop trading, but rather in market making. To explain this distinction: market making is viewed as a benign provision of liquidity; the idea is that the market maker serves humanity by making it less expensive for market participants to buy and sell securities. In exchange for this service, the market maker collects the bid/ask spread. Market making is sometimes viewed as a relatively conservative endeavor. In contrast, the term “prop trading” more often refers to making strategic bets. Whereas the market maker might get short a small amount of stock for a couple days because a customer wanted to buy it, the prop trader will heavily short the stock believing the company will soon go bankrupt. These distinctions are entirely arbitrary; market making is prop trading and I believe it is impossible to distinguish the two with regulation.

Since banks are allowed to continue market making and it is almost impossible to distinguish market making from other prop trading, I’m deeply skeptical that Obama will be able to prevent banks from engaging in risky prop trading. This is all conjecture though, since we have no idea what form the initiatives will take. My best guess is that Obama will enact legislation that will look very menacing but most of the big banks will find loopholes to continue business as usual. To the extent that the legislation succeeds in reducing prop trading at banks, the winners are the largest hedge funds that will step in to fill the void.

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