Too Much Skin in the Game or Too Little?
The NYT is reporting today on the Administration’s latest round of proposed regulations for the financial sector. Among other things, the proposal includes the so-called Volker Rule, which would prohibit proprietary trading by banks. ”Prop trading” is when an institution makes investments in financial assets using its own capital, rather than its clients’ capital. When an investment banker works with other people’s money, he lives off of commissions. When he does prop trading, he lives off of the profits from the trade itself. The idea behind the Volker rule is that prop trading is just too tempting for bankers to handle. It holds out the possibility of huge profits but by putting the firm’s capital on the line it makes institutions more brittle. And so President Obama wants to ban it.
It seems to me, however, that there is a real tension between this approach and some of the regulations in the House’s recently passed bill. In particular, the House bill laid the blame for the financial crisis at least in part on the originate to distribute model of mortgage lending, insisting that from now on banks need to hold at least part of the residual risk for the loans that they originate. The idea is that when banks have more of a skin in the game, they will not make stupid loans or get swindled by fast talking mortgage brokers selling them subprime junk. Banning prop trading, however, is all about reducing the amount of skin that the banks have in the game. After all, playing with your own money — capital — rather than other people’s money is the ultimate skin in the game. Furthermore, many of the proprietary trades that the Administration is now castigating were in MBSs and CDOs produced by the banks themselves. In other words, rather than using the OTD model to off load subprime risk, a lot of banks were securitizing pools of mortgages and then buying the resulting securities with their own capital. In effect, securitization was less about off loading risk than about transforming an illiquid asset into a (supposedly) liquid asset.
It seems to me that policy makers have a deep schizophrenia in their reactions to the banks, arguing that they were both under- and over-incentivized with regard to mortgage transactions. Of course, there are other problems with prop trading, including a lack of transparency and the temptation for banks engaging in prop trading to increase their returns by over-leveraging themselves. Prohibition, however, strikes me as a rather ham fisted response.
UPDATE: Here are Christine Hurt’s thoughts on the announcement.