This post has basically nothing to do with Paul Volcker but it is convenient that he gave his name to this rule because otherwise illustrating posts about bank proprietary trading would be very challenging. So, thanks Paul! Photographer: Joshua Roberts/Bloomberg
This post has basically nothing to do with Paul Volcker but it is convenient that he gave his name to this rule because otherwise illustrating posts about bank proprietary trading would be very challenging. So, thanks Paul! Photographer: Joshua Roberts/Bloomberg

I guess the Volcker rule comes out tomorrow and you can read about it then but why should its nonexistence stop you today? Here are DealBook and Bloomberg News articles that are best read as companion pieces: Bank lobbyists think that the Volcker rule is too strict and will sue to weaken it, while anti-bank lobbyists think that it's too lenient and will lobby to strengthen it. No one knows what it says. Opinions, and lawsuits, on whether it's too strict or not strict enough do not turn on what it actually says. As Tyler Cowen puts it: "Many people, even seasoned commentators, approach the Volcker rule with mood affiliation, starting with how much we should resent our banks or our regulators or how we should join virtually any fight against either 'big banks' or regulators."

I guess I'll sidle over to the anti-Volcker-rule side of the mood affiliation.1 I mostly think the Volcker rule -- which will prohibit U.S. banks from engaging in "proprietary trading" but with exemptions for "market-making" and "hedging" -- is dumb for all the obvious reasons. It is impossible to conceptually distinguish "prop trading" from "market-making," so the Volcker rule will make market making more difficult and expensive and reduce market liquidity.2 It is impossible to conceptually distinguish "prop trading" from "hedging," so the Volcker rule will make banks less hedged and more risky.3

But the biggest conceptual objection to the Volcker rule is that its central premise makes no sense. Proprietary trading had basically nothing to do with the financial crisis, and banking is about taking "proprietary" risk with depositor money. This is mostly called "lending," but calling it "lending" doesn't make it safer than calling it "prop trading." The reverse is mostly true; here's a blog Cowen cites:

But the notion prop trading is inherently riskier or subject to greater realized losses than plain old lending, as we saw in 2008, is flawed. Loan losses didn’t just dwarf trading losses in absolute terms. Loan losses as a share of banks’ total loan portfolios also exceeded trading losses as a share of banks’ trading accounts. Yet no one’s arguing banks should stop lending in order to protect depositors (and rightly so). In short, those expecting the Volcker Rule to be a fix-all for Wall Street’s ills have probably misplaced their hope — the rule seems like a solution desperately seeking a problem.

Sure, that seems right! Everyone knows this! This has been discussed for years! Who cares? No one cares. If you're in favor of a strong Volcker rule, cutting down on prop trading risk is a good thing even if that risk isn't, objectively, especially risky. If you're against a strong Volcker rule, you've been saying "prop trading is less risky than lending" forever and no one has listened to you and they won't start now or even tomorrow. Unless you sue them, I don't know.

Is there a way to justify the Volcker rule that is less conceptually terrible than, "well I mean prop trading is less risky than lending but more risky than gardening so we might as well do something"?4 One place to start might be to consider the ways in which lending really is safer than prop trading. That's a very generic question -- some loans, and some trades, are riskier than others -- but one very generic answer is that the trading book is marked to market and the lending book is not.5

If you start there you get what I think is a pleasingly subversive view of the Volcker rule. Lots of things are fungible with lots of other things. Things that are cast as "proprietary trading" can easily be recast as "lending." Mortgages can come in mortgage-backed-security flavor on your trading book, or in whole-loan flavor on your lending book. You can give hedge funds leverage by writing them swaps (prop trading! though also maybe market-making! feh!) or by lending them money (lending!). Actually you don't even have to recast trades as loans to avoid the Volcker rule: Just recast them as trades that you intend to hold for at least 60 days and you should be good.6 (Especially if you actually hold them for at least 60 days.)

Is that a realistic prospect? Will banks revise the documentation and wording of a trade to achieve roughly the economic goal of proprietary trading without calling it "proprietary trading"? Are they banks? Here:

“Morgan Stanley and Goldman Sachs will go out and hire the best and brightest lawyers, and they will say, ‘How do we do this?’ ” said Bill Singer, a securities lawyer who represents individuals and brokerage firms in disputes with regulators and advises clients on regulatory compliance. “The mind-set,” he said, is “how do we get around it?”

So what good does that do? Well, if banks shift the same activity from "prop trading" to "lending" then, at the margin, they're shifting from a purely mark-to-market world to one with more scope for avoiding mark-to-market losses. At the margin, they become a bit more opaque. They can hide volatility in lending and available-for-sale activities, reducing the effect of market volatility on things like bank earnings and capital.7

Is that bad? I dunno, that's a question of mood affiliation. You could quite reasonably take the view that banks are supposed to be opaque, because the job of banks is to disguise risk. On this view, the big banks' move in recent years from a largely actuarial held-to-maturity approach to finance, to a largely mark-to-market trading-based approach,8 has -- umm, not exactly increased transparency, but at least made it more obvious that banks are subject to market risks. You could worry that this transparency and mark-to-market has procyclical effects: When markets panic, mark-to-market banks lose money, causing further panic.

On this view, you might be happy that the Volcker rule has some tendency to make the risks of banking less transparent. Of course, if you were pro-Volcker-rule to begin with, that's probably not what you want to hear. Ha, sorry.

Here's Tyler Cowen again:

We still seem unwilling to take actions which would transparently raise the price of credit to homeowners. We instead prefer actions which appear to raise no one’s price of credit and which are extremely non-transparent in their final effects. You can think of the Volcker rule as another entry in this sequence of ongoing choices. That should serve as a warning sign of sorts, and arguably that is a more important truth than the case either for or against the rule.

Sure, probably. But that sequence of choices is not a particularly post-2008 sequence. Everybody always wants banks to provide cheap and plentiful credit without taking any risks. If the Volcker rule is another attempt to achieve that fantasy, maybe it's not all bad.

1 The official Bloomberg View mood affiliation is the other way: "Will the Volcker Rule Be Tough Enough?" seems to exclude the possibility that it will be too tough. Matt Klein's on my side, though.

2 Or, sure, drive it to nonbanks, smaller broker-dealers or hedge funds or high-frequency trading firms or whatever. The Bloomberg View editorial thinks that would be a good thing, though it doesn't say why. If prop-trading-slash-market-making has an element of systemic risk (and surely it does?) then it seems like a bad idea to push it out to less-regulated and less-capitalized market makers.

3 And the Volcker rule will (apparently!?) require bank executives to certify that they're not engaging in prop trading, while (maybe!?) giving regulators after-the-fact discretion to decide what is and isn't prop trading, creating the possibility of criminal violations for guessing wrong about your regulator's future state of mind. That seems like a bad idea.

4 Cowen's main pro argument is, "If restricting activity X makes large banks smaller, that will ease the resolution process, following a financial crack-up." Fine, but the Volcker rule is a circuitous way to get there.

5 Except at Goldman! Very generic answer. Technically speaking ASC 320-10-25 and 320-10-35 divide securities into "trading securities" ("with the intent of selling it within hours or days," mark-to-market through the income statement), "held-to-maturity securities" ("positive intent and ability to hold those securities to maturity," held at amortized cost) and "available-for-sale securities" (everything else, no effect on income statement but mark-to-market on the balance sheet and through other comprehensive income).

6 I mean, no one knows what the rule says, but the draft rules seem to assume that trades of 60 days or less are prohibited and trades of longer than 60 days are okay. (See Step 1 of this flowchart.) I guess that could have changed but that part doesn't seem to be particularly controversial.

7 Held-to-maturity loans aren't marked to market for income or capital purposes, though obviously they can suffer impairments for actual or expected losses. Available-for-sale securities aren't marked to market for income but are for capital, more or less. See 78 Fed. Reg. 62,058-62,061.

8 Nicholas Dunbar's "The Devil's Derivatives" is a good account of (portions of) that shift. Friedman and Kraus's "Engineering the Financial Crisis" is a good argument for the procyclicality of mark-to-market accounting.