Volcker Rule essential: CFA

Banks may be fighting the Volcker rule, but many industry professionals would welcome stricter trading regulation for large banks and institutions.

With the recession and global woes still weighing on markets, tougher rules would help bring companies down to size, after having too long embraced the too-big-to-fail mentality. Mark Carney suggested as much in Halifax during a speech about the global economy.

Read: Carney discusses crisis, calls for open financial system

Improved regulation would also help calm investors and taxpayers worldwide, since their funds would be protected from the downfalls of major, faltering companies.

In particular, the multi-billion-dollar loss suffered by JP Morgan recharged the debate about how to ensure banks remain strong and competitive, while stopping them from becoming so big and complex that they threaten financial systems.

While Jamie Dimon has continued to stress the loss was due to trading in credit derivatives, rather than proprietary trading, he admitted from the start it was a grievous mistake and black mark on the part of the bank, considered one of the world’s strongest during the recession.

In the aftermath, many were left wondering if its trading misfire indicated Wall Street banks have become too big to both fail and manage.

Immediately following the news, CFA’s head of capital markets policy, Jim Allen, wrote a blog about how a large company was bound to get caught trading derivatives “like it was a reunion of 2007 risk traders,” and about the dangers of proprietary trading.

In his view, the fact that a major bank was caught is good for taxpayers and your clients, since “arguments for a lighter-touch Volcker Rule now sound hollow.”

Read: Investors shouldn’t blindly trust Wall Street

We spoke to Allen about his blog post and his views on bank regulation. Read more on his thoughts:

Katie: Kurt Schacht, managing director of the Standards and Financial Market Integrity division of CFA Institute, said, “Big banks need to get on the integrity bandwagon, clean house, and stop chasing the next big buck. They must eliminate any and all prop trading, particularly that disguised as market making.” What are your thoughts on his statement?

Jim Allen: The bank, as a general rule, is there to operate on behalf of its investors. Also, because of the times we’ve been in and the sizes of some of these institutions, there’s also the issue of their call on the taxpayer.

They shouldn’t be engaged in activities that put people’s investments and tax dollars at risk, and should always act with a high degree of integrity under solid internal controls.

K: You thought it was surprising that JP Morgan suffered such a major loss. Dimon had such a good reputation, and the bank made it through the crisis well. What are your thoughts concerning their actions and mistakes?

JA: JP Morgan is an institution that has remained at the top. They were one of the few big banks that avoided a lot of the problems with subprime lending markets. In this case, it seems the big whale trader in London was taking some outside positions and got caught on the wrong side.

That tends to be a control issue….read more on page 2 about how the rule could benefit investors, and how to talk to clients about major, negative headlines.

That tends to be a control issue, but the reality is you can’t really control what’s going on moment-by-moment at the trading desk. We support the intention of the Volcker Rule for this reason; it will make sure that these kinds of incidents don’t put the money of companies, shareowners or taxpayers at risk.

K: How should investors be reacting to news about JP Morgan and major, failing companies?

JA: In JP Morgan’s case, a $2 billion loss was 1% of the capital. It’s an outrageously large loss and 1% of capital is nothing to sneeze at. But, they’re reasonably well capitalized compared to a lot of other firms.

Investors should address this dilemma, and others like it, by looking at the leverage and capital that these institutions have, as well as the kind of reports, disclosure and activities they’re engaged in. Track what companies are doing and follow their performance to make sure they’re not taking outside risk. They should be engaged in market making as opposed to proprietary trading.

K: The recession has certainly tested client’s relationships with their advisors. How should advisors approach negative headlines and news, as well as discuss the stability of banks with their clients?

JA: Communicate with clients and tell them what you know about what is happening. Make sure clients know how it affects them—if it does at all—and how it relates to their portfolio and investment policy statement. Advisors need to keep tabs on current news and need to communicate any issues with their clients right away.

K: How can proprietary trading be defined?

JA: In our letter to the SCC and regulators, we said defining prop trading, and distinguishing between hedging and market making, will be a challenge.

If something is a hedge, but sounds like prop trading and has significant basis risk, it will most likely be flagged. But, distinguishing between the three practices is not easy.

In my opinion, market making activities and market trading should be done at a broker dealer; an affiliate and separately capitalized entity that has no call on the capital of the institution or it’s liquidity. That trading operation is more or less walled off from the original banking institution.

As I understand it, that’s the structure Canadian banks currently operate under. It’s a preferable system and probably easier to regulate, and would save officials from having to come up with hard definitions for prop trading and hedging.

As you put down a definition, every institution will try to determine what it can do to get around that new description legally.

K: In your blog, you said JP Morgan getting caught is opportune for taxpayers. How?

JA: There was a fair bit of push back from institutions like JP Morgan regarding the Volcker Rule. This has happened and it happened at JP Morgan. It was a big loss but manageable loss, and they were able to absorb it.

However, it put banking regulators and policy makers on alert that these things can even happen to the best of institutions. If this had happened to a bank that didn’t have the balance, liquidity, experience or expertise to handle the aftershock the way JP Morgan did, things may have been much worse.

It shows they need to be pushing forward on something like the Volcker rule. That way, institutions couldn’t put the depository institution at risk as a result of risky trading activity. If regulators allow this kind of trading to occur, it could cost taxpayers money down the road.

It’s fortuitous that it was JP Morgan, since it gets people thinking about the problems that might occur if poorly capitalized institutions start making similar errors.

Let’s say it was a rather large institution, in the US or elsewhere, that didn’t have the balance sheet or the expertise. They would have lost a significant chunk of their capital and would have caused investor panic, with too many people pulling back from the market like in 2008.

K: Your thoughts on Jamie Dimon?

JA: He’s guided JP Morgan through some rather turbulent times and has done a good job. He took the steps to hold the people that were responsible accountable. That’s what you want. It would take a lot for the company to vote him out, and at this point, it would be the wrong move.