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Study: Time to Stop Banks From Risky Trading

Via Mark Gongloff, the IMF has released a new study showing that, in essence, the world would be a much safer place if international banks stopped trading in the financial markets.

Why can’t banks just trade like George Soros and everybody else? Why can’t they have any fun? A few reasons:

First, banks have tons of capital laying around, relative to, say, a hedge fund, which specializes in trading. The bigger the bank, the more capital. A bank would almost be crazy not to gamble with that capital to make more profit. That’s especially the case in economic environments like, say, a crappy recovery from the worst recession since the 1930s, when interest rates are at rock-bottom and banks are afraid to lend money. With their share prices crushed, regulators banging on the door and the government making loud noises about how they’re not going to bail out any more banks, it’s all too tempting for a bank to take some of that extra money it has laying around and take it down to the pari-mutuel betting parlor.

“As a result, banks trade too much, and in… too risky a fashion, compared to what is socially optimal,” Boot and Ratnovski write.

You can see evidence of this in JPMorgan Chase’s London Whale trade, which because of the access to capital became a far greater loss for the bank. Heck, the entire financial crisis shares this dynamic as well.

Arnoud Boot of the University of Amsterdam and Lev Ratnovski of the IMF have a blog post at VoxEU if you prefer not to read the whole paper. But the upshot is that banks trade too much and take on too much risk. Restoring safety and soundness to the financial system would dictate that banks make their money from taking deposits and making loans rather than trading on their capital. Essentially, Boot and Ratnovski endorse something like the Volcker rule (although on a wider scale), a way to wall off proprietary trading at institutions with federal deposit insurance. You can be an investment bank that gambles, or you can be a commercial bank involved in deposits and loans. You can’t be both, or at least you shouldn’t be, according to this report. What’s more, the attractiveness of fast money-making through trading takes capital away from the investment and lending sides of the banking business, which reduces economic activity.

Felix Salmon reacts:

Once again, at the margin, it makes sense to put a little money into trading. The bank’s cost of funds is low, for one thing. And for another thing, the risks of trading are asymmetrical. If it works, the shareholders make money. But if it fails, the losses can be so huge that the whole institution blows up — which means that not only do shareholders lose money, but so do bondholders. This, weirdly, is a good thing from the shareholders’ point of view, because it means they don’t need to bear the full cost of trading blowups. And just about any bet, if you don’t have to bear the full potential downside, thereby becomes much more attractive […]

In an ideal world, then, banks simply wouldn’t be allowed to trade at all. What’s more, in that world the banks would quite possibly make more money than they’re making right now. But you’d need globally-coordinated regulation to get there, and it’s simply not going to happen. Which is why trading blow-ups are here to stay — and regulators are always going to be on the back foot when it comes to trying to prevent them.

That’s probably true. In fact, Boot and Ratnovski express “surprise” at the lack of a coordinated policy response. But they add that proper understanding of the economic forces at play adds to that. And that’s what their paper is all about; explaining the need for walling off this trading for the benefit of the global financial system.

Or, we can just continue to have a cascade of bank failures and bailouts caused by completely preventable activities with no social utility above the actions people take in a casino.

More here.

Photo: Thomas Becker/

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David Dayen

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