10/08/2012 04:04 pm ET

Banks Will Always Suck At Trading, Badly Need A Volcker-Like Rule: Study

Science has spoken: Banks are doomed to suck at trading forever and should be stopped before they crash the global economy again.

A new study by economists Arnoud Boot at the University of Amsterdam and Lev Ratnovski at the International Monetary Fund finds that recent blow-ups in the banking sector -- JPMorgan Chase's $6.8 billion "London Whale" losses and that whole financial-crisis thingy, to name two -- are not isolated events, but "a sign of deeper structural problems in the financial system."

The only prescription? Less trading by big dumb banks.

"Without policy action, crises associated with trading by banks are bound to recur," Boot and Ratnovski write in a blog post about the paper. "Even strong supervision will not be able to prevent them. Consequently, it appears necessary to restrict trading by banks."

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.

One problem with this dangerously bad incentive is that banks use the capital for trading rather than lending money, their more-traditional role. This can move capital away from long-term constructive uses (financing factories or schools, say) and toward not-so-constructive uses (gambling on subprime mortgages).

And this looks like a permanent state of affairs, because technological developments and financial engineering have made markets deeper, giving banks many, many more ways to get themselves into trouble.

"This means that while trading in banks was benign and contained before, it has irreversibly become more distortionary now," Boot and Ratnovski write. By "distortionary," they mean that in the sense both that it distorts financial markets and that it also distorts the economy by shifting too much money to socially useless trading.

For this reason, Boot and Ratnovski say, the do-everything bank model of the end of the 20th Century -- think Citigroup -- is obsolete and "no longer sustainable."

The solution, they argue, is something like the Volcker Rule -- or at least the original intent of the Volcker Rule before it got lobbied into uselessness -- prohibiting banks from trading on their own account. They also think banks shouldn't be allowed to take on some other risks, such as buying and holding a bunch of securitized debt, as Washington Mutual did.

They say banks should be allowed to underwrite stocks and bonds, and should be allowed to hedge their bets, saying "small trading positions" probably won't bring down the global economy.

That last part has been the rub all along, though -- banks argue that it is impossible to tell the difference between sensible hedging and crazy trading. JPMorgan insists its London Whale trade was supposed to be a hedge, which might have been allowed under the Volcker Rule.

You can bet that banks -- who will always burn with a desire to gamble their spare cash for higher returns -- will try as hard as they can to carve out exceptions to any trading curbs that are eventually put in place.


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