We were as surprised as everyone to hear what U.S. Representative Paul Ryan of Wisconsin told constituents at a meeting on May 4.

“If you’re a bank and you want to operate like some nonbank entity like a hedge fund, then don’t be a bank,” the House Budget Committee chairman and the Republicans’ leading policy wonk said. “Don’t let banks use their customers’ money to do anything other than traditional banking.”

We agree. Although Ryan didn’t say so, he was endorsing the Volcker rule in the Dodd-Frank financial reform law. Inspired by former Federal Reserve Chairman Paul Volcker, the rule is supposed to stop federally insured banks from making speculative bets for their own profit -- leaving taxpayers to bail them out when things go wrong.

Banks have both explicit and implicit federal guarantees, so the market doesn’t impose the same discipline on them as, say, hedge funds. For this reason, the Volcker rule should be as airtight as possible.

Recent Bloomberg News stories about huge trading positions taken by the London branch of JPMorgan Chase & Co.’s chief investment office help drive home the point. Operating much like a hedge fund, the investment office built a position that may have totaled $100 billion in a credit-derivative index known as the CDX, which tracks the default risk of a basket of companies.

Skewed Prices

Although their precise size and purpose aren’t known, the trades -- bets that companies in the index wouldn’t default on loans -- generated distortions in a $10 trillion market. For a while, the price of the index actually diverged from the price of default insurance on the individual companies underlying it. The skewed values adversely affected investors and others who relied on the instrument to hedge hundreds of billions of dollars of bond holdings.

The trades also stirred debate among U.S. policy makers wrangling over the Volcker rule, complicating the job of JPMorgan Chief Executive Officer Jamie Dimon, who is leading the industry charge against the rule. Dimon sought to downplay all the fuss as a tempest in a teapot. If so, it’s a very large teapot. “It’s a big portfolio,” Dimon said in a conference call with investors. One sign that the chief investment office may do more than hedge can be seen in its daily trading risk -- it’s about the same as JPMorgan’s investment bank, which includes Wall Street’s biggest stock- and bond-trading units.

In truth, the London trades fall into a gray zone in the Dodd-Frank law. The act gives regulators discretion to exempt “risk-mitigating hedging activities” for “individual or aggregated positions” from the proprietary trading ban. JPMorgan argues that it was following the letter of the law because its trades were meant to hedge the bank’s overall portfolio risk. If the Federal Reserve and other bank regulators agree, they could write a Volcker rule that allows such trading to continue.

We don’t mean to pick on JPMorgan, but such large positions could be speculation masquerading as market making. (The Volcker rule permits banks to conduct legitimate market making.) After all, taking large speculative positions in derivatives markets is a tempting shortcut to profits and bonuses. Almost any trade by a large bank could be made to look like a hedge -- and regulators would be hard-pressed to prove otherwise. The problem is that giant trading positions can backfire as easily as they can pay off.

We urge regulators not to view such portfolio-hedging trades as benign. The final Volcker rule, which could come as early as this summer, should require banks to put boundaries around trading activity with a risk profile that includes estimates of losses under various worst-case scenarios. Regulators should approve these profiles and have the ability to monitor compliance.

True Market Making

Regulators could also look at how long a trading desk has been holding its inventory of securities. The average for a big market-making operation should be a matter of days. And they should know what percentage of trades a desk makes with clients, versus with other securities dealers. If most trades are with customers, the bank is probably doing true market making.

Overseas regulators are considering alternative approaches that could work just as well. The U.K. allows banks to conduct proprietary trading as long as they split their banking and securities activities into independent, separately capitalized entities, an approach known as ring-fencing. The European Union is considering requiring risk profiles and higher capital requirements for securities that aren’t easily sold.

Banks say these rules will impair their ability to act as market makers in service to clients, harm liquidity in bond markets, and impose costs that will reduce lending and slow the economy. What banks don’t mention is that depositors’ money will be safer, taxpayers won’t have to bail out big banks that suffer large trading losses, and financial crises and recessions may occur less often. Even Paul Ryan seems to agree: That’s a lot of upside.

Read more opinion online from Bloomberg View.

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