Let banks trade securities — it's where their future lies

Reuters

Article Highlights

  • Securities markets are an inherently more efficient way to finance than deposit banking.

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  • Capital markets are where growth is occurring today.

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  • Reinstating Glass-Steagall will solve the problem of banks that are #TBTF -by condemning them to fail in a big way.

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Sandy Weill's switch in time—calling for the reinstatement of the Glass- Steagall Act—again raises the question whether eliminating the trading activities of banking organizations would make banks safer and more likely to write good old-fashioned loans.

This is the view of the lawmakers who backed the Volcker Rule in the Dodd-Frank Act barring banks from trading securities for their own accounts.

Will the Volcker Rule or reinstatement of Glass-Steagall reduce the risks of banking organizations or induce them to make more loans? The answer to both these questions is no.

"The idea that banking organizations can be profitable solely or principally as lenders, or that this would be good for them or the U.S. economy, is based on a vision of the economy and the capital markets that no longer exists." -Peter J. WallisonThe idea that banking organizations can be profitable solely or principally as lenders, or that this would be good for them or the U.S. economy, is based on a vision of the economy and the capital markets that no longer exists. As former Senator Phil Gramm once said, if you want your grandfather's banks, you'll have to restore your grandfather's economy.

According to the Fed's flow of funds data, the securities market has far outstripped banking in providing private sector credit over the last 45 years. Although bank lending and securities market financing were about equal as credit sources in the mid 1960s, the securities markets began to sprint ahead in the 1980s.

By 2011, if we consider all private sector borrowers, including housing and consumer credit, banks had supplied $6.2 trillion in financing over the 45-year period while the securities markets had supplied over $22 trillion. In lending to business corporations, banks supplied about $1.5 trillion while the securities markets provided credit financing of almost ten times as much, about $15 trillion.

It's relatively simple to understand why this happened. The securities markets are an inherently more efficient way to finance than deposit banking.

In a bond financing, for example, the issuing firm pays a commission or underwriting fee to the intermediary that places the securities with investors. But when a firm borrows from a bank it must pay for the bank's risk in holding the loan over an extended period, plus the bank's additional costs of borrowing the necessary funds in the form of deposits or otherwise, deposit insurance, and supporting a large regulatory apparatus.

At one time banks had an informational edge over other forms of intermediation. They knew more than potential investors about the creditworthiness of particular borrowers. But this advantage was swept away by the corporate disclosure required of securities issuers, coupled with technological advances in real-time communications. By the late 1980s, investors could assess credit quality for themselves. 

So it becomes clear why banks are more interested in trading securities than in lending. Their most creditworthy potential customers—for good economic reasons—are financing in the securities markets, and will continue to do so in the future.

The capital markets are where growth is occurring today and if banks want to be profitable in the future they won't be able to do it solely or even principally by making loans. Accordingly, reinstating the Glass-Steagall Act will solve the problem of banks that are too big to fail – by condemning them to fail in a big way.

Moreover, it is in the growing securities markets where banking organizations can provide the most valuable services through their trading activities.

In order to operate efficiently, the securities markets must have a mechanism that allows investors to trade debt securities when they want to alter their portfolios. This requires institutions with capital to stand ready to buy and sell these bonds and other instruments—in other words, to make markets. Banks are ideal for this purpose, but it involves buying and selling securities for the bank's own account—exactly what the Volcker Rule is supposed to prohibit.

The rule contains an exception for market-making and hedging, but even this brief description of market-making suggests how difficult it will be for regulators to draft a rule that permits banks to buy and sell securities as market-makers or for hedging purposes, but not for their own accounts. Much turns on what was in the trader's mind when the trade was put on, making it particularly unsuitable for defining and enforcing through a regulation.

In reality, the Volcker Rule will impose an unenforceable distinction between proprietary trading and other legitimate bank activities, depriving banks of full participation in the growing capital markets while virtually requiring that traders have a lawyer at their elbows when they pursue market-making and hedging. No business can operate this way.

Although proprietary trading is frequently characterized as "betting" there is little indication that it is riskier than lending—which of course is long- term bet on a borrower—but it allows banks to compete in a growing market where they have clear expertise and add real value.

Nor is there any evidence that banks' trading had a role in the financial crisis. Banks suffered losses there because they bought and held for investment what are in effect loans—AAA-rated securities backed by mortgages.  

If we want to limit banking organizations primarily to lending, we will have to tell them where to find the creditworthy borrowers, and we will have to find substitutes to make markets in debt securities. On the other hand, if we want banking organizations to survive as profitable entities we should let them function in the capital markets that exist today—not those that exist only in our memories of a simpler time.  

Peter J. Wallison is the Arthur F.  Burns Fellow in Financial Policy Studies at the American Enterprise Institute.

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