From Mr Dennis M. Kelleher.

Sir, Tom Braithwaite’s Inside Business column “Volcker conundrums fuel confusion over rule” (December 20) did an excellent job of presenting the banking industry’s criticism of the Volcker rule. The claim is that the Volcker rule ban on proprietary trading will interfere with their “market-making” ability for clients and that market liquidity will suffer. Legitimate market-making will be discouraged, banks say, because the metrics that regulators propose for identifying prop trading will produce false positives, and are so complex that they cannot be understood.

One conundrum is that Mr Braithwaite doesn’t mention why the Volcker rule exists at all: banks’ prop trading is high stakes gambling, which is also highly leveraged. Banks love this because it is enormously profitable and, as has been annually demonstrated, results in tens of billions of dollars in bonuses. However, as the world learned in 2008, when those bets go bad, banks fail and taxpayers have to bail them out to prevent the financial system from collapsing. The Volcker rule merely tries to end or limit taxpayer exposure from banks’ reckless prop trading. This is hardly a radical or unreasonable goal.

Thus, the real issue is whether or not banks can be effectively prohibited from engaging in reckless trading activities in a way that minimises the impact on other desirable banking activities like market-making. And, the real problem arises because the casino-like returns from prop trading, and the lure of the big score, provide plenty of incentive to disguise prop trading as something else like, you guessed it, market-making.

The metrics of the proposed rule, or improved versions of them, will prevent some of this evasion, but not all. Contrary to the industry’s criticism, the problem, no matter what metrics are used, will be false negatives. The rule-writers have tried to reduce this risk and close off likely avenues of evasion by proposing the use of multiple metrics.

There are no doubt other changes that can improve the rule’s ban on prop trading without impairing legitimate banking activities. For example, limiting compensation to only fees and commissions (which is all that should be generated from the non-prop trading permitted activities) would eliminate the incentive for traders to make big disguised bets to obtain outsized returns. This could easily be policed after-the-fact by examining and disaggregating the bonus pools: big returns come from big risks and most often big bets, aka, prop trading.

We can all agree that the proposed rule is far from perfect. But killing it ostensibly in favour of other ways to improve bank safety such as increasing capital and moving derivatives trading to clearing houses ignores an inescapable reality: banks are trying to kill or gut all those rules as well. Working in good faith to improve the Volcker and the other rules is essential if there is any hope of having a stronger, safer banking industry that is less prone to crisis and failure and thereby in need of yet more taxpayer bail-outs.
 

Dennis M. Kelleher, President and Chief Executive, Better Markets Inc, Washington, DC, US