Last week, a bad trade left J. P. Morgan Chase with a massive loss of at least $2 Billion (and counting). CEO James Dimon admitted responsibility for the unsuccessful position that a trader nicknamed London Whale took, resulting in the major loss. Mr. Dimon said the trade was “failed, complex, poorly reviewed, poorly executed and poorly supervised“.
This is not the first time a trade goes wrong. There are other infamous cases of rogue traders that incur in unauthorized operations. Notable precedents include major write-downs (and even winding down) for banks like Barings (1995, Nick Leeson), Société Genérale (2008, Jérôme Kerviel) and more recently, UBS (2011, Kweku Adoboli). The difference with the JPM trade is that the operations of broker London Whale had apparently been authorized.
This situation has both the UK Financial Services Authority (FSA) and the US Securities Exchange Commission investigating what happened to existing controls. Whatever the outcome of these investigations may be, the discussions amongst financial regulators, public policy makers and academics have once again centered around the purported benefits of adopting the “Volcker Rule” in order to reduce such risky bets (and losses) in the banking system.
The so-called “Volcker Rule” refers to a series of measures proposed by former US Federal Reserve chief Mr. Paul Volcker. This reform was captured in the Dodd-Frank Act, the U.S. bill that attempts to correct the errors that led to the Financial Crisis. The measures seek to significantly restrict banks from trading securities in their own account (also known as “proprietary trading”).
The rationale behind this policy is to reduce risks in banks’ trading books. This principle is not novel. It is a revamp of the historical Glass-Steagall Act type segregation between commercial banking and investment banking that Franklin Roosevelt promoted through the New Deal.
The Volcker Rule seeks to promote that banks focus on their lending activities. By restricting proprietary trading, regulators try to mitigate bank risk-taking in assets that often don’t show up in their balance sheets until they become losses. This is functionally equivalent to separating dealing (acting on your own behalf) from securities brokerage (acting on someone else’s behalf), in order to reduce moral hazard and mitigate exposures for ensured depositors (in turn, saving taxpayers’ money).
There are several reasons why banks buy and sell securities on their own account. For example, banks can negotiate and take positions in derivatives in order to hedge risks. Banks can also buy and sell securities to manage their daily cash flow and liquidity needs. However, banks also engage in active trading on their own account in order to maximize their profits and distribute more dividends to their shareholders. Some commentators, like Mr. Volcker, understand that often these proprietary investments are merely speculative in nature. Potentially, higher risk-taking means higher profits, but also the likelihood of encountering larger losses.
In the dominican regulatory framework there is a functional segregation between banking and securities brokerage. However, “multiple services banks” and credit and savings banks can engage in proprietary trading and derivatives in accordance with Articles 40 and of the Monetary and Financial Law No. 183-02 (the “MFL”). Regulators construe that these operations exclusively relate to these financial intermediaries acting on their own account (dealing) in contrast to actions on behalf of third parties or clients (brokerage).
Although the dominican securities market has virtually no derivatives trading, with the revamping of securitization as amended by the Trusts and Mortgage Market Development Law, this inactivity is destined to change. It is anticipated that the Dominican Republic will soon have an emerging derivatives market, including the key market participants required for it to work properly (primarily, a clearing-house). This doesn’t entail that the banks are not engaging in over-the-counter derivatives transactions in order to hedge risks. They are taking positions and this is consistent with international best practices in risk management.
Therefore, regulating proprietary trading in the Dominican Republic should not be a policy priority at the moment. It would be like trying to extinguish a flame that has no yet started burning. Before undertaking any regulatory change, we should follow up on how the global financial regulatory landscape continues to unfold. Who knows? maybe in a few years, the Volcker rule becomes a standard principle of sound financial regulation.