Streetwise Professor

January 23, 2010

A Further Thought on the Volker-Obama Plan

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 11:34 am

I think it’s always worthwhile to work through the likely equilibrium effects of policy changes, to recognize that such changes will affect not only what is directly targeted, but will also induce other responses that can dampen, and even reverse, the intended effects of the policy change.

Let’s consider the unintended, equilibrium effects of Volker-Obama.  The V-O plan should affect big deposit taking institutions–universal banks–most acutely.  JP Morgan-Chase, Citi, BofA in particular.  The plan essentially forces firms to make a choice between being depository institutions or prop shops.  (Backdoor Glass-Stegall, if you will.)  The cost of becoming a prop shop would be very high for Morgan, etc.  So they are likely to jettison these operations, and become relatively old style banks again.  And that’s exactly what Obama and Volcker want.

But consider the effects of the exit of some players from prop trading.  They were presumably in the prop trading business because it was profitable.  Their exit creates a profit opportunity for somebody else.  In the first instance, potentially a Goldman or MOST that can become pure prop shops exempt from the restrictions at lower cost than Morgan, Citi, and BofA.  Moreover, currently smaller players may expand their prop trading, or new entrants will come in to take advantage of the opportunities.

In other words, someway, somehow, the exit of the deposit taking banks from prop trading will induce expansion and entry by others.  These others, in turn are likely to be quite large and systemically important.  Especially because VO doesn’t address the underlying source of TBTF–the government’s inability to commit NOT to intervene to bailout the creditors of a failing, interconnected, failing institution.  (Thought experiment: V-O is likely a boon to Citadel and D.E. Shaw.  Thinking back to LTCM, do you think that if one of these firms got into serious trouble, that some sort of government intervention would occur?  Yeah, the investors in the hedge funds would be wiped out, but that’s not the point.  To the extent that their counterparties, and the banks that finance their operations are convinced that they would be protected in the event of a big hedge fund collapse, they are willing to trade with and extend credit to them, permitting them to expand excessively.)

This means that equilibrium responses will undermine the effects of VO.  It is likely that VO will reduce the amount of prop trading, especially if there are synergies between this activity and other forms of intermediation offered by universal banks.  But it may lead to a greater concentration of what prop trading remains in the hands of a smaller number of less diversified firms.  Remember that the main casualties of the crisis were, in the first instance, Bear Stearns, Lehman, Merrill, and almost Morgan Stanley and Goldman.  If anything, the V-O plan would increase the number, size, and importance of these kinds of firms.  That’s hardly reassuring. Yes, these types of firms would not benefit from the deposit insurance system, but that doesn’t mean that they aren’t effectively guaranteed anyways if they become big enough.

Yes, we definitely need to do something to deal with moral hazard.  I’m just not convinced that the V-O framework does that.  Given that prop trading is apparently profitable, V-O will lead primarily to a shifting around of who does prop trading.  Yes, deposit taking institutions will do less of it, but others will swoop in to take advantage of their exit.  We’ll still be left with implicitly guaranteed institutions with an incentive to grow too large.

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  1. Fannie Mae, Freddie Mac, AIG, GM, and Chrysler top the list of firms that will not repay their bailout money. Citigroup may or may not cost the government money. Of the firms that won’t be paying us back, NONE are depository institutions (if we ignore the possibility of Citi).

    Why isn’t this the first thing mentioned about this proposal? Oh, right, we pine for the days of Paul Volcker’s M1 targeting.

    Comment by Highgamma — January 23, 2010 @ 4:23 pm

  2. Just want you to know I was at a dinner with Thom Hartmann last night and suggested that he contact you to be on his show. I sent him a link to this website. He regularly talks to Krugman,Reich, Dean Baker and Batra. I thought you would be a great addition to his experts. I suggest you contact him at [email protected].

    Comment by nate — January 23, 2010 @ 6:20 pm

  3. And now Obama is a star. He is featured in a movie– exposing greedy hedge funds and market manipulation called “Stock Shock.” Even though the movie mostly focuses on Sirius XM stock being naked short sold to hell, I liked it because it shows the dark side of Wall Street. DVD is everywhere but cheaper at

    Comment by Matt Fan — January 24, 2010 @ 10:58 am

  4. So we create a bunch of highly leveraged prop shops that have capital exposures ringfenced from the balance sheets of the banks. That doesn’t change the fact that the prop shops are still going to be using ungodly amounts of borrowed money in the course of their daily activities. Capital exposure may be ringfenced by credit exposure won’t be. If the prop shops are leveraged 100 to 1, and the banks are counterparties to the prop shops, the risk to the financial system is still the same.

    That amazing thing to me is that we still haven’t sat down and admitted exactly what caused the meltdown in the financial system but we are hell bent on moving ahead with new regulations.

    If you want smaller banks, tax bank assets above the desired threshold so that growing assets above a certain level would be unprofitable. Its not rocket surgery we are talking here.

    Comment by Charles — January 24, 2010 @ 1:41 pm

  5. Charles–exactly. I mean, it was the investment banks that blew up first and biggest, and big non-bank (AIG). None of this had anything to do with deposit insurance or the Fed discount window. If implemented V-O would just create another bunch of big, highly leveraged, fragile IBs that would still be considered prime candidates for a bailout.

    Matt–Thanks. Always looking for finance-oriented entertainment 🙂

    The ProfessorComment by The Professor — January 24, 2010 @ 2:14 pm

  6. Poor JP Morgan that just went all in with a $4B Sempra deal.

    Comment by Surya — January 25, 2010 @ 8:08 am

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