How do you ensure that firms do not take proprietary positions? Do you require that the bonds be bought directly from a customer? If so, how do you police it?

 By Larry Tabb, Founder & CEO, TABB Group, developers of TabbFORUM.com January 28, 2010

In September 2008, within a few weeks of the fall of the house of Lehman, I had written the following, excerpted from my research note titled, "The Future of Investment Banking: Subprime and what it Means for The Industry."

A New Glass Steagall

As investment banks are consolidated into commercial banks and the fixed income businesses look to tap into the lower cost of funding associated with deposits and commercial banking endeavors, I also would not be surprised if we get a new Glass Steagall-type of legislation which will again draw the lines between investment and commercial banks.

While Glass Steagall mostly split investment and commercial banking across equity/corporate underwriting (investment banking only) and fixed income (both investment and commercial banking) lines, most if not all of the challenges stemming from the subprime crisis occurred on the commercial banking side. It was not the equity side of the business that blew-up; it was the fixed income side, which has historically been thought of as the safer side. I don't think that the government would split out the mortgage or the loan business from the commercial banking side; however, besides better managing the amount of leverage implemented on commercial banks, I could easily see that various risk-type businesses being split from these US Universal Banks.

This may mean that while these new Universal Banks have both equity and fixed income businesses, that the Universal Banks would be prohibited from proprietary trading, taking sizeable risk positions, and or underwriting corporate securities (both equity and corporate debt), leaving the Universal Banks' role in capital market as more of a processor, custodian, and agency trading operation rather than engaging in proprietary trading capitalized by deposits, and nave investor capital.

While I assume that President Obama and Paul Volker didn't read this, I believe that the direction is sound. Why are we allowing depository institutions to leverage inexpensive and taxpayer-guarantee funding to take proprietary risks where both the shareholder and by default the taxpayer bear the risk?

Now that said, implementing a policy like this will be extremely difficult. The banks, of course, will fight it but even ignoring the fight " how do you practically implement this type of strategy and even if you do, how will this impact the global financial markets?

Defining Prop Trading

Defining proprietary trading will be next to impossible. Investment banks take risks and separating the proprietary risks from market-making risks or client-servicing risks will be difficult. While there are people within the banks with proprietary trading roles, many of the positions held by the proprietary traders would be virtually indistinguishable, from an outside perspective, from market-making / customer-facilitation positions. For example, how would the regulators distinguish the following positions?

• First, the bank sees an opportunity to buy $50 million of undervalued US auto debt, and
• Second, a large mutual fund wants to unload $50 million in US auto industry debt and the bank offers to execute the trade using its own capital to facilitate the trade

While the first example is clearly a proprietary position and the second is not, how would a regulator distinguish between these two positions? In both cases, the firms has built up a position in US auto debt. In both cases the amount is $50 million. The positions from an auditor's perspective would look identical. Today, these positions are differentiated by the trading accounts in which they are housed. While this is good for accounting purposes, I am not sure this will pass muster with regulators.

So how do you ensure that firms do not take proprietary positions? Do you require that the bonds be bought directly from a customer? If so, how do you police it? Proprietary positions don't need to be acquired only via inter-dealer brokers. Do you require a recording of the client conversation? Do you just fire the proprietary traders? Do you segregate proprietary and customer-facilitation positions by a holding period test? What if you can't find the other side of the trade? Do you force the bank to sell the products at a loss? Do you force the bank to only act in an agency position? If you do this, then the bank would need to either increase its sales force dramatically or lower the price of the bonds to attract an immediate counterparty. I am not sure issuers, or investors, would care for either solution.

If we look to tease proprietary trading from customer facilitation and market making by holding period, many firms have a proprietary, high-frequency, equity / options / futures trading business. These businesses take very short term positions looking for liquidity gaps. While many firms call this proprietary trading, much of this can also be called market making. What is the difference?

Will we be able to tell what is proprietary from market making by the portfolio/trading account they are traded out of? I am not sure that will be effective.

Liquidity

Properly defining the difference between market making, customer facilitation and proprietary trading is critical. If the government makes it too difficult for banks to take positions, then there will be less liquidity in the market, meaning fewer buyers and sellers, wider spreads, and greater costs not only to trade but for companies, and for that matter. governments to raise capital.

The impact of this across asset class will be significant. Products that employ less capital will be less impacted. Exchange-traded products such as equities, options and futures will have little impact since these products are for the most part traded "as agency" (meaning the banks don't take big positions in these markets " except to hedge other less-liquid positions) and the risk-taking functions within these asset classes have effectively migrated from banks to other market participants such as high frequency traders. So if regulators could tease apart proprietary trading from market making and customer facilitation and banks eliminated their proprietary trading, market liquidity may change somewhat over the short-term but other players will quickly and easily fill in the gaps.

The products I expect would be more severely impacted are over-the-counter (OTC) traded products such as debt, currency, and all types of OTC derivatives. To support these products, large banks leverage their balance sheets and capital to make these products liquid. Separating market making, customer facilitation and proprietary trading for these products is much more difficult and if done incorrectly would leave a huge void in the market.

Without the dealers in these markets, liquidity and turnover would initially dry up, spreads would increase, and it would become much more expensive for companies and governments to raise capital and manage risk. This would have a dramatic impact on not only corporations but the government. The current debt ceiling is $14 trillion; a one-basis point (.01%) increase in funding would cost taxpayers $1.4 billion a year. Given that one-basis point is very small and global debt is huge, it will only take a small increase in interest rates to significantly impact both issuers and taxpayers.

o court more liquidity and solve this gap, we would need to draw more liquidity providers into the markets. Since liquidity providers couldn't be large banks, we would need to adjust the products to enable smaller firms to partake in these markets. To accomplish this, OTC products would need to be made more standardized, and trading would need to be done in smaller denominations. By standardizing these products, it would turn these bespoke products from securities and derivatives created by corporations and governments for specific capital-raising and risk management purposes into trading products that may not benefit the financial end users. If a corporation needs specific covenants on a bond to raise capital or needs to insulate themselves from an economic event, how does a generic and standardized product help them accomplish this goal? It just creates basis risk, forces the corporation to move toward private equity, ignore the opportunity, or self-insure the risk " which will force corporations to reduce investment, take less risk, and will eventually impact the number of jobs firms create.

Aversion

Assuming that we can define and ban proprietary trading from customer facilitation and market making and can prohibit these practices, how will banks react?

First, banks will determine if they can avoid this regulation by changing their registration. Goldman Sachs and Morgan Stanley were historically investment banks and not chartered as Bank Holding Companies (BHC).

What if these organizations dropped their BHC registration? These firms have paid back their TARP money and currently have less reliance (possibly none) on the federal government. Would this mean they were suddenly safe? Would they no longer be too big to fail? My guess is, if either of these organizations just dropped their BHC status, continued their business as usual, and subsequently got into trouble, the government would just bail them out again. So just dropping a firm's BHC status would not be enough.

Second, banks would think about if they could switch their proprietary trading businesses to overseas entities, say Switzerland or somewhere in Asia, maybe Singapore. If this concept takes hold, it would be likely that these organizations would create walled-off subsidiaries or switch their registrations to more loosely regulated jurisdictions where these practices would be less regulated or maybe even encouraged. I am sure that some country would be interested in importing thousands of bankers generating millions of dollars in bonuses, which of course would generate huge tax windfalls and generate a multiplier effect of support jobs.

Third, if neither of these cases were possible, then banks would spin off these organizations, not shut them down. This would allow the proprietary traders to either buy out these businesses using either their own capital, private equity, or carve out the proprietary trading business through a spin off. The spin-off and capitalization of new trading businesses has been happening for years. Since the mid-1980's, brokers and banks have supported the spin-off of traders and trading desks into separately capitalized hedge funds and proprietary trading firms. Banks/brokers have developed prime brokerage businesses to facilitate this. By spinning off these businesses, it transfers the trading risk to a separate entity while retaining a fee-based revenue stream through trading commissions, lending and financing. So this may not be as awful a problem as anticipated.

Risk Shifting

As hinted above, if banks just clove off proprietary trading operations, it won't mean that they won't profit from prop trading or eliminate their exposure to proprietary trading. Banks will just shift this exposure from direct to indirect exposure. While banks may not trade for their own accounts unless investment banking and retail/commercial banking is completely separated, the larger banks will continue to have economies of scale over smaller shops. This scale allows larger banks to borrow and trade less expensively than smaller prop shops. These economies of scale will allow the banks to lend money, finance, and provide trading facilities for independent proprietary trading firms much like they provide prime services today. While a proprietary trading ban will reduce their exposure to risky assets, it will not eliminate them altogether because these same risky assets will be pledged as collateral to provide financing for independent providers. This will reduce direct exposure to these assets; however if the assets go south, the banks will still be left holding an empty bag.

A Better Solution

A much better solution would be to more carefully adjust / fine tune capital guidelines within banks to promote or dissuade banks from taking risky positions. Capital allocation could be employed to require banks to increase their capital ratios depending upon the size and composition of their balance sheet. They could be forced to hold greater amounts of capital for more risky, less liquid, and greater sized positions. By increasing the capital ratios on these more risky positions, it requires that the returns on these positions be greater to justify their investment. In this case, banks must either double down and take way more risk (which increases capital ratios even further), or eliminate their risk and allocate to a much safer investment " which is more likely.

In addition to adjusting capital allocations, we should also look to see what type of capital banks are holding. Currently, tier-one capital is calculated on their total balance sheet and not based upon the assets held. Tier-one capital may be in the form of illiquid real estate assets, asset-backed securities or for that matter US Treasury bonds. We should look to ensure that the capital the firms are pledging/holding is not junky illiquid, miss-marked, or unable to be accurately marked, and ensure that pledged capital is of good quality, liquid, and safe.

Washington Politics

While I believe managing capital is a more fundamentally practical solution than shutting down proprietary trading, it is probably not politically practical. Washington needs scalps and must show that they are in control of Wall Street and not visa versa. Washington will not be able to declare victory by just saying that they kicked Wall Street's "behind" by changing capital ratios. That will not get anyone re-elected. The problem, unfortunately, is that unless the government is much smarter than they seem, the politically expedient solution may either have significant unintended consequences or be completely unenforceable " with the latter being much better than the former.

The Bottom Line

While I am all for figuring out a way to reduce risk from the banking sector and wholeheartedly agree with the idea that banks shouldn't use taxpayer-guaranteed deposits to fund risky trading practices in which banks and traders receive the bulk of the upside potential and little if any of the downside risk " I am not sure that banning proprietary trading as the de facto solution is the right answer.

Banning proprietary trading will be difficult to enforce and if made too draconian could absolutely hurt corporations, governments, taxpayers, and Main Street by shrinking the level of corporate financing.

While I am in favor of protecting the economy from another collapse, we need to think long and hard about doing this in a practical way " otherwise the unintended, or for that matter intended, consequences of a rash act may make the regulators feel better but would hurt not just Wall Street, but Main Street, and the global economy as well.

Larry Tabb is founder and CEO of TABB Group, the research and strategic advisory firm focused solely on capital markets. *TABB Group recently launched TabbFORUM, the first-ever online community for capital markets professionals to share and contribute opinions on current issues affecting their business.