Too Much Skin in the Game or Too Little?

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6 Responses

  1. Ken Rhodes says:

    Nate wrote: >>Among other things, the proposal includes the so-called Volker Rule, which would prohibit proprietary trading by banks. ”Prop trading” is when an institution makes investments in financial assets using its own capital, rather than its clients’ capital. When an investment banker works with other people’s money, he lives off of commissions. When he does prop trading, he lives off of the profits from the trade itself.

    … It seems to me, however, that there is a real tension between this approach and some of the regulations in the House’s recently passed bill. In particular, the House bill laid the blame for the financial crisis at least in part on the originate to distribute model of mortgage lending, insisting that from now on banks need to hold at least part of the residual risk for the loans that they originate. The idea is that when banks have more of a skin in the game, they will not make stupid loans or get swindled by fast talking mortgage brokers selling them subprime junk. Banning prop trading, however, is all about reducing the amount of skin that the banks have in the game.>>

    The problem with the foregoing, I think, is the phrase “the game,” as though there were just one game. There are two very different games. One is the “game” banks traditionally played, in which they lent money to borrowers at a higher rate than they paid for the money, with the spread being profit on the loans. It was strongly in their interest to minimize risky loans, since on those they had to foreclose, the costs were high.

    Under Glass-Steagall, that was the business of retail banks, while investment banks and brokers of all sorts were free to package debt and resell it. Now, for some years, insurance companies are combined with retail banks are combined with investment banks are combined with stock brokers (including the underwriting function) and there is a different “the game” in play–the buying and selling (including insuring and short-selling) the debt instruments. That “game” is a capital gains game, based on how well the player assesses the future rise and fall of the value of the paper, and it’s a totally different game than the game of lending money. A bank can make a nice profit on a seven percent loan, but if the prevailing rate goes to eight percent, then the paper representing the ownership of the loan goes down quite a bit. That’s a type of risk that speculators accept every day, but which jeopardizes the stability of retail banking.

  2. Nate Oman says:

    Fair enough. I suppose that I am less convinced that the two games can be so neatly separated, particularly in a world where the retail banks are not holding to maturity the loans that they are originating, and where much of people’s savings are tied up in things other than deposit accounts. Retail banking as a stand alone model, it seems to me, is heavily dependent on walling consumers off in a world where they have limited access to other forms of investment. That world died a generation ago, and I am not convinced that nostalgia for it provides a good lens for thinking about reform. Also, I think it is pretty clear that the Administration is upset about prop trading by investment banks rather than commercial banks.

  3. BDG says:

    Nate, you argue that prop trading is the bankers playing with their “own money.” But isn’t the real problem that many of these firms have an implicit bailout promise? So there’s a very large moral hazard problem, which is difficult to avoid. Claims that there will be no bailout are not especially credible. I guess the gov’t could enact a statute saying something like, “no bailouts for banks that fail because of prop trading,” but that, too, is not really credible. Thus the direct ban. No?

  4. Nate Oman says:

    BDG: I agree that the real problem is bailouts. It seems to me that rather than trying to pick out the transaction du jour that we think caused the latest round of problems and then banning it, we ought to find ways of credibly committing to no bailouts. This is really really hard. On the other hand, I think that something like requiring living wills and giving regulators increased power to wind down insolvent institutions may make sense. If we are going to regulate risk directly, it makes more sense to me that we do it using something like higher capital requirements for large institutions. After all, the risk of prop trading is ultimately not that the bank will lose money (they get to lose money; them losing money is good; losing money is what makes capitalism work!). Rather, the risk is that they will be over-leveraged and fail in some systemically damaging way. If this is the problem, don’t go mucking around with the particulars of making money off of commissions or off of prop trading. Just regulate the levels of leverage for systemically important institutions.

  5. Nate Oman says:

    BDG: For what it is worth, Megan McArdle seems to more or less follow your argument, namely that it is impossible to withdraw the implicit guarantee of Goldman et al so what we ought to do is regulate their ability to take on risk. In my more pessimistic moments, I’m inclined to agree that there is no way of unringing the bailout bell once it has tolled and that regardless of the law it is the implicit guarantee that matters. I just hope it isn’t so, I suppose…