The problem with too much regulatory discretion: what is hedging versus proprietary trading

Once again, the Wall Street Journal editorial board focused attention on a major unsolved problem in the financial sector:  too much regulatory discretion.

Prior to the beginning of the financial crisis, regulators used their discretion to change the relationship between themselves and the financial institutions.  In place of the 1930s' adversarial regulator/regulated relationship, they substituted an ally protector/client relationship.

No where is this better exemplified than in the discussion over the Volcker Rule.  As the WSJ observed

Thursday's surprise news of J.P. Morgan's $2 billion trading loss shows again why taxpayers don't want to stand behind Wall Street trading desks. But nailing down a precise definition of the Volcker rule, which was supposed to prevent taxpayer-backed gambling in the securities markets, is proving to be harder than forecasting changes in the Chinese politburo. 

Even the seemingly mundane task of figuring out when the rule will take effect has become a challenge. A recent letter on Volcker from the Federal Reserve is Washington's latest monument to opacity.

Regular readers recall that opacity in the financial system was the necessary condition for the financial crisis.  So naturally, they recoil when regulators embrace opacity.

Opting for hazy regulator discretion over bright statutory lines, a Democratic Congress joined with President Obama in 2010 to create Dodd-Frank. 

Among other things, the law purported to include former Fed Chairman Paul Volcker's concept to ban so-called proprietary trading at banks that enjoy federal deposit insurance. In other words, the banks could fulfill customer orders but they could not make trades for their own account. No more betting the firm's capital when the taxpayer is the ultimate backstop....

As previously discussed, translating the Volcker Rule into regulations is actually simple.  It has two parts, first, a paragraph explaining that banks could fulfill customer orders but they cannot make trades for their own account; second, a paragraph explaining that banks will have to provide ultra transparency and disclose to market participants on an on-going basis their current asset, liability and off-balance sheet exposure details.

It is this disclosure of details that effectively means banks will adhere to the rule.  If they take a trading position, they have to worry about a) the market trading against them and b) having to liquidate the position under regulatory order when the market participants point out the position is not there for fulfilling customer orders.

Almost two years later the Fed still hasn't decided what the Volcker rule will say ... how narrow or wide its trading ban will be....

Clearly the Fed has used its regulatory discretion to move from the simple translation described above to a much more complicated formulation of the rule.  What the Fed first proposed was over 200 pages long.

It's true that the prospect of some kind of Volcker rule has reduced trading activity at the big banks and led to the closure of numerous Wall Street desks dedicated to proprietary trading. The traders are moving to less regulated hedge funds and private-equity shops. 

But looming higher capital rules could have the same effect by restricting the leverage that has fed the trading operations at giant banks. Higher capital rules can also be applied with more uniformity and transparency.

However, higher capital rules would not be nearly as effective as ultra transparency.  Had the Fed simply required ultra transparency, it could have achieve the intent of the rule.

The danger of Volcker, as rendered by Washington and as suggested in the Fed's recent letter, is the danger that exists throughout Dodd-Frank. 

It is the taxpayer danger that results when regulators prone to capture by the industries they regulate are vested with huge authority and discretion to favor some activities while disadvantaging others, and to help some firms while harming others.