Opponents of new financial regulations are starting to claim that JP Morgan losses don’t show us much about the need for new restrictions on bank activities. First, they say, risk is inherent in banking, and no restriction can eliminate it. Second, there’s no benefit in restricting the types of risks that are taken — traditional lending risk permitted under the Volcker Rule is the core problem in financial oversight. An anonymous banker summarized the argument in a statement to Politico’s “Morning Money” last week:
“The inconvenient truth is that ‘plain vanilla’ lending is far and away the riskiest activity any financial institution can engage in. Virtually every financial crisis in history – including the most recent one – was caused principally by lending-related losses. The value of mortgage-backed securities plummeted in 2008 not because those securities were traded, but because too many of the mortgages… backing those securities were poorly underwritten … The notion that we can legislate or regulate risk out of banks is absurd.”
First, the banker is dead wrong about the relationship between trading risk and the 2008 crisis. The loans packaged into mortgage-backed securities were indeed poorly underwritten. (One reason is exactly that the loans were sold off into traded securities –underwriting practices can become lax if the lender does not plan to keep the loan). But the losses from those loans, while severe, would not by themselves have created the financial crisis we saw in 2008. As Ben Bernanke stated in a recent speech, aggregate subprime loan losses amounted to several hundred billion dollars, not in itself enough to take down the global economy. Problems in the mortgage market triggered the collapse because of a vast structure of financial market trades based indirectly on the value of those mortgages. That structure included trillions of dollars in synthetic derivatives bets (synthetic CDOs), as well as trillions of dollars in short-term (overnight) funding tied directly to traded valuations. That was the structure that collapsed and took the economy down with it.
Second, no one is trying to – or could – ban risk from banking. The goal of the Volcker Rule is instead to change the form and location of risk. The rule moves one particular type of risk –proprietary speculation in the financial market ‘casino’ – out of the giant banks at the center of the economy and into smaller hedge funds and other speculators who can fail without threatening the system. The Volcker Rule permits banks to continue risk taking in the form of lending and investment, as well as low risk forms of market making.
That’s because risks created by financial market gambling differ in important ways from those created by long term investment and lending. Financial markets are inherently unstable and volatile, vulnerable to bubbles and crashes. At the extreme, markets can fail completely during periods of panic and trading can become impossible. When institutions central to the economy are gambling their money in these markets, the entire system becomes more vulnerable. Supervisors can require banks to reserve capital against this risk, but today’s speculative instruments can create enormous financial exposures that are very difficult to predict. Determining those exposures relies on complex and uncertain mathematical models that have a history of spectacular failures (and just failed JP at Morgan yet again).
That’s the risk part of the problem. There’s also the connection to the real economy to think about. Speculating in secondary trading markets occurs at several layers of remove from real economy capital provision. Much of the volume in today’s financial markets is just derivatives bets on future prices, with no actual lending or investment involved. There are some risk management benefits for hedgers. But the real economy benefits of, for example, the exotic credit derivatives JP Morgan was speculating in appear limited at best. And paper speculation can actually suck money away from the real economy.
In contrast to financial market speculation, lending and long-term investment have a direct real economy connection and the risks are easier to understand. Exposures are more straightforward and underwriting is less dependent on complex mathematical assumptions and more on assessing basic creditworthiness. In addition, when lending goes wrong the banker often has time to ride out the problem and restructure the debt. Speculative market exposure forces loss recognition immediately and makes banks vulnerable to contagious market panic.
So the Volcker Rule builds a firewall between speculative trading and basic credit intermediation. Banks can take risks in traditional, longer-term lending and investment, but their financial market activities should be limited to low-risk market making and hedging. Banks are resisting this shift, since their business models have mixed market trading and basic banking functions in so many ways. But it’s strange that anyone should find the basic idea outrageous, since it’s the same distinction made in one of the most famous and long-lasting regulations in American history, namely the Glass-Steagall division between depository and investment banking.