The Volcker Rule and Margin Requirements for the Layman

Banking reform and the “Volcker Rule” have been front-and-center in the news for the past couple of weeks after President Obama dramatically announced that he would impose sweeping stringent rules on the banking sector.  He told banks they would no longer be able to take risky bets with their own capital to make money in the financial markets.

The implication of this was that those institutions calling themselves “banks” would fall under “Banking Regulatory Guidelines” and would not be able to trade the financial markets, essentially re-instating the Glass-Stegall Act.   Also known as the Banking Act of 1933, Glass-Stegall in part separated commercial banks who took deposits from investment banks who took bigger risks.  It also created the FDIC. In reality, it was supposed to prevent banks that took depositors’ money from making risky investments following the great crash of 1929.

This legislation remained in place until 1999, when certain provisions were repealed through the Financial Services Modernization Act, including the prohibitions that prevented a bank holding company from owning other financial companies, including investment banks.   I guess it’s time we got less modern?

I am going to oversimplify some points here for the sake of brevity and simplicity, so if you are an economist or bank analyst, please understand 

I don’t think the government understands enough about derivatives, trading, or the banks’ specific complex internal structure to enact such a drastic change that would have such a polarizing effect.  Potentially, some banks could lose tons of money while investors and others benefit.  I also do not think the government will gain international support to pass as robust and restrictive plan as they may have thought.

We still don’t have any specifics on a plan and don’t think we will for some time.

The government should maybe look to the exchanges and the Options Clearing Corporation (who guarantees all options transactions), both of which have been very good at managing risk and setting margin requirements.

As a market maker, I was subject to those rules every day and was still able to make a good living.  For every trade made, there is a counter-party involved.  In other words for every share that is bought, one has to be sold, etc.  So in essence, in every trade, by itself, there is a winner and a loser, period.  But as we all know, professional traders typically hedge their positions. In other words, if I buy 100 shares of Goldman Sachs (NYSE: GS), I may sell 20 shares of the S&P 500 Index short as a hedge or buy an out-of-the-money put in GS, to either reduce my losses if the trade goes against me or buy some insurance (the put) to prevent catastrophe and put an absolute limit on my downside.

Another way to modulate the risk is to enforce position limits and certain margin/capital requirements on certain trades.  For example, if I only have $10,000 dollars in my account, I am only able to risk $500 in any given sector. Basically, this can prevent someone without the money or knowledge from making a trade they can’t cover if it went against them.

Professional trading firms do this frequently, as do to the exchanges for their members; traders must have enough capital or cover their position if things were to go against them, and this risk is determined by several factors, one of which is historical volatility of the underlying stock or instrument. (Mr. Volcker touched on this as well)

Unfortunately, the mortgage-backed securities models that some firms were using were obviously not conservative enough, not to mention most over leveraged their investments (borrowed too large of a portion of their investment/risk dollars).

In specific, maybe the government should look at the possible risk of a particular security or derivative and compare that to their existing risk/assets.  From there they could derive a “risk measurement” and have some rules in place that compel the bank to either reduce their exposure by exiting the position or buy a put-like instrument that helps cut risk to a certain level that is congruent with their capital at hand.

Remember, we can’t ensure the banks will be on the right side of all the trades or investments they make, but what we can do is help ensure that one bank is NOT holding all the losing trades and is thus forced into failure. Sometimes, collapse is inevitable, by the way, and I think Mr. Volcker is correct in that we have to let them fail, let the markets be free and operate without the hand of some politician meddling with the natural order of things.

Some rules or guidelines are okay, but stifling already deeply integrated banks, which are trying to recover along with all of us, is not good for our economy.  The markets are like water, they will always find the path of least resistance.