Study shows that banks always suck at trading

The Huffington Post carried an interesting article on a study by economists that shows that banks always suck at trading.  The conclusion is that banks need to have their trading restrained.

Regular readers know that the best and simplest way to restrain trading by a bank is to require it to disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

With this information, market participants can see what trades the bank is making and can exert market discipline to restrain risk taking.

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."

The only way to successfully restrict trading is through market discipline and the only way to subject banks to market discipline is to require they provide ultra transparency.

Ultra transparency is a trader's worst nightmare.  All market participants get to see what he is doing.  

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....

"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).... 

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. 

Please note that requiring banks to provide ultra transparency achieves everything that the authors would like.  Under market discipline, banks will scale back their trading for their own accounts as well as the risk they take on from holding structured finance securities.

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. 

The beauty of ultra transparency is that it doesn't interfere with a banks ability to underwrite stocks and bonds, nor does it require them tell the difference between sensible hedging and crazy trading.

Under ultra transparency, the market simply restrains the amount of risk they can take related to these activities.

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.

So long as there is ultra transparency, the market will restrain their actions.