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Home > Blogs > Ian Fraser > Volcker’s right: Prop trading was at heart of crisis

Volcker’s right: Prop trading was at heart of crisis

Finance Blogger: Ian Fraser Ian Fraser

There are plenty of powerful voices on Wall Street and in Congress out to rubbish President Obama’s ‘Volcker Rule’ right now. Their main gripes are that it won’t really work in practice (since it doesn’t apply to many banks and that others will find ways around the proposed rule), and that the rule will undermine the competitiveness of US banks and diminish their ability to lend to the real economy.

So it’s reassuring to hear that one of the US’s most respected investment managers, Jeremy Grantham, founder of Boston-based GMO, has come out four-square behind Obama’s proposals.

Grantham, whose business has some $100bn in assets under management both in long-only and absolute return funds, is renowned for his ability to spot speculative asset price “bubbles” ahead of the game and for steering clients clear of impending busts.

He has avoided a whole string of investment train wrecks, including the Japanese equities bubble of the 1980s, the dotcom bubble of the late 1990s and the bank shares and real estate bubbles of the noughties. With this sort of record, he is a man worth listening to.

On January 21, President Obama broke ranks with other world leaders when he said his administration would limit the activities in which deposit-taking institutions (i.e. those that are eligible for taxpayer-funded bailouts and safety nets) can engage. These included proprietary trading (using other people’s deposits to underpin trading on their own account), private equity and hedge funds.

As the dust begins to settle on the proposals—which harp back to the days of Glass-Steagall, when banks had to choose between investment banking and deposit-taking, with the goal of keeping deposit-taking institutions out of the “casino” in the interests of better risk management and the avoidance of conflicts of interest—Mr Grantham declared that proprietary trading was “the rot at the heart of our financial problems.”

Writing in a special edition of GMO’s Quarterly Newsletter, he said:

"Everyone knows prop desk trading (banks trading their own capital like a hedge fund) is a conflict of interest. They may or may not think it important or that it caused this or that problem, but they know it’s a real conflict. Congressmen, since when wasn’t conflict of interest and poor ethical standards reason enough to change the law?

But since we bring it up, of course prop trading was indeed the rot at the heart of our financial problems (see last quarter’s Letter). Watching traders take home their $28 million bonus sent a powerful message to lowly salesmen and packagers of asset-backed securities, for example, to get out there and really take some risk. This rot spread to the very top, and pretty soon chairmen of boards were exhorting CEOs to leverage up and look more like some much more profitable rival that resembled a hedge fund rather than an investment bank.

Thus encouraged—or intimidated—some CEOs just kept on dancing right off the cliff. Let’s learn from our near disaster. Viva Volcker!"

Nouriel Roubini, one of the few economists who can genuinely claim to have seen the crash coming, said the Volcker Rule does not go far enough. But in a recent newsletter he conceded that: “More radical reforms, like breaking up too-big-to-fail financial firms and returning to Glass-Steagall-type restrictions, that are needed to stave off asset bubbles and tame systemic risk may be politically difficult to implement.”

It seems that Paul Volcker’s recent attempts to explain his proposals to the US Congress did not go down too well (according to some reports anyway) But as Barack Obama readies himself for a bruising fight to get the proposals through Congress, at least there are a few voices of sanity from within the US financial elite willing to back him all the way.

Further reading



Tags: asset price bubbles , banking , Barack Obama , Glass-Steagall Act , hedge funds , Paul Volcker , private equity , proprietary trading , regulation , US
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