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July 24, 2012

The Volcker Rule, Jamie Dimon & the Whale's Splash

            The Volcker Rule prohibiting most proprietary trading and all but de minimis investments in hedge funds by banks that benefit from the federal financial safety net or are otherwise systemically significant is an essential reform.  It effectively applies to only the biggest too big to fail banks because they are really the only ones that engage in any substantial proprietary trading or hedge fund investments.  Moreover, as explained in detail in the first of Better Markets’ three comment letters on the Volcker Rule, while some continue to deny it, proprietary trading by those systemically significant financial institutions played a key role in the financial collapse and economic crisis.

            Proprietary trading is fundamentally no more than wild speculating by making huge leveraged bets with the banks’ money for the purpose of hitting the jackpot and reaping an enormous windfall.  Thus, this type of very high risk trading offers vast and fast wealth to those working for these too big to fail institutions.  However, if those bets go wrong, as they did in 2007 and 2008, they can lose massive amounts of money very quickly and drag down an entire bank, which then has to be bailed out so it doesn’t take down the entire financial system.

            However, the law also carefully carves out certain permitted, socially desirable activities such as market making and risk-mitigating hedging.  To avoid the big banks from disguising improper proprietary trading as a permitted activity (which they are highly incentivized to do given the gigantic bonus potential), the permitted activities are carefully defined.  For example, permissible market making must be “designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties.”  The permitted activity of “risk-mitigating hedging” is also very carefully defined in the statute.  Most of the industry’s so-called concerns and objections to these definitions appear to be no more than attempts to create loopholes in the definitions of permitted activities so that they can continue their high-risk, but lucrative, proprietary trading.

            Reinforcing the ban on proprietary trading and ensuring that the permitted activities don’t become such loopholes, the Volcker Rule also prohibits, among other things, any “transaction, class of transactions or activity … if the transaction, class of transactions or activity … would result, directly or indirectly, in a material exposure by the banking entity to high-risk assets or high-risk trading strategies ….”

            Thus, the recently reported trading by JP Morgan Chase’s Chief Investment Office (CIO) in London (the so-called “London whale”) almost certainly would have violated the letter and not just the spirit of the law and proposed Volcker Rule.  First, given the enormous net gains (reportedly 25% of the bank’s net income for 2010) and losses (now reported to be approaching $9 billion) arising from this trading activity, it cannot properly be described as “hedging.”  And, given the swings in net profits and losses, it cannot properly be characterized as “risk-mitigating hedging,” which is the definition of the permitted activity.  Moreover, it has been widely reported that JP Morgan’s CEO personally transformed the CIO from a low-risk hedging operation into a “profit seeking” operation;  real “risk-mitigating hedging” does not generate net profits, which is what the CEO reportedly structured and staffed the CIO operations to create.  (While losses and profits may be generated, they should be largely offsetting, resulting in little net profit or loss.)

            Moreover, the JP Morgan CIO’s trading certainly involved “high-risk assets” and “high-risk trading strategies,” which are also expressly prohibited by the law.  This is proved not only by the net profits and losses generated, but also by the fact that the CIO had to wager vast amounts of money to create those profits and losses, reportedly involving hundreds of billions of dollars.  The CIO had, by the CEO’s admissions, more than $350 billion under its control and much of that was apparently bet by the “London Whale” seeking to make a big splash and get a huge bonus, if not other rewards.  Proving the high-risk nature of these assets and trading strategies, they apparently involved relatively illiquid securities because the bank couldn’t exit the investments in any reasonable period of time to minimize its losses.

            As if all that wasn’t enough to demonstrate beyond a doubt that JP Morgan’s trading violated the law and rule, it is also the case – as the CEO himself has admitted – that those very high risks were unknown to the bank; the bank’s CEO, CFO, and other executives; and risk and operational management.  The narrow permitted activity of “risk-mitigating hedging” cannot, by definition, occur by accident, which is why the proposed rule has detailed procedures to establish that such hedging is in fact risk mitigating and in fact bone fide (although, as set forth in Better Markets February 13, 2012 comment letter, those procedures need to be strengthened). 

            Thus, the incentives to engage in this high risk behavior are enormous and must be addressed directly, which Better Markets did in its comment letters by focusing on compensation.  Moreover, we addressed with specificity the industry’s complaints regarding their claim that the rule will reduce their ability to act as market makers for corporate bonds, i.e., the alleged liquidity concerns.  In this regard, it is noteworthy that the industry did not provide information or data on their own purported inventories to show (rather than merely claim) how the proposed rule would impact liquidity. 

           They do rely on a paper by the consulting firm of Oliver Wyman.  Given that the paper was purchased by SIFMA on behalf of the industry, it is no surprise that it agrees with SIFMA’s and the industry’s position on the Volcker Rule.  Like their arguments, however, the paper is deeply flawed.  Better Markets addressed these flaws in its comment letters (specifically in the April 16, 2012 and June 19, 2012 comment letters), but I will briefly address the primary flaw here:  Oliver Wyman, without explanations or basis (and contrary to basic economics), assumed that there would be no new entrants into the business of market making if the biggest too big to fail banks stopped making markets as a result of the Volcker Rule (which itself is a highly dubious assumption because market making is an expressly permitted activity).

         Specifically, the Oliver Wyman paper stated that “[w]e do not directly analyze a wide range of potential knock-on effects, including… [t]he potential replacement of some proportion of intermediation currently provided by Volcker-affected dealers by dealers not so affected.”  As set forth in our comments letters of February 13, 2012, April 16, 2012 and June 19, 2012, there is, however, a great deal of historical and contemporary evidence that entry is the normal market response to profit opportunities like this, including recently in the corporate bond markets. 

          This should come as no surprise to anyone.  After all, the big dealer banks are not  nonprofit organizations and do not make markets for free.  They do it to make money and because there is money to be made.  If they don’t make that money, other market participants will move into the business to reap the profits. 

          Frankly, most of the industry’s other objections simply don’t stand up under the most minimal scrutiny either.  For example, they claim that it is almost impossible to distinguish between proprietary trading and market making or hedging.  This is simply baseless.  Such activities have been going on for decades if not centuries or more and there has not been any evidence of widespread confusion over those activities………..until the Volcker rule banning proprietary trading was proposed. 

        Wall Street has some of the highest paid people in the world and many claim that they are the smartest people in the world, but all of a sudden they can’t tell the difference between activities that have been distinguishable for years, decades and more?  These are self-interested complaints that seek to get the law and the rules re-written in a way that would allow the biggest banks to continue their wildly lucrative proprietary trading by a different name (which is what JP Morgan Chase and its CEO were apparently trying to do with the London CIO operations).  While that would increase Wall Street’s profits, it would yet again risk a raid on taxpayer’s pockets and it must not be allowed.



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