Role of proprietary trading at banks

The conspiracy mongers are having a field day with the tale of the rogue trader at Societe Generale, suggesting that the Federal Reserve was a gullible victim of his handiwork and should have somehow known better and even anticipated the event! Read about it in the article in The New York Times by Nelson Schwartz and Nicola Clark entitled "Societe Generale's Sales May Have Incited Market Plunge."

First of all, to be quite clear, the Fed is not chartered to manage asset prices, whether they be housing, commodities, bonds, or stocks. The Fed is also chartered to respond to events in the financial markets to assure stability and liquidity in the markets. As events were unfolding on Sunday, Monday, and Tuesday, there was a lot of disruption in the financial markets, including talk of markets reacting to economic conditions and outlook, which made the situation on Tuesday morning something the Federal Reserve needed to respond to.

One of Wall Street's so-called "professionals" who has irresponsibly helped to fuel the fantasies of the conspiracy theorists was Barry Ritholtz, someone who should know better. As The Times tells us:

"I have little doubt that Societe Generale's unwinding of those positions absolutely pressured indexes worldwide," said Barry L. Ritholtz, chief executive of FusionIQ, a New York-based investment research and money management firm. "And wouldn't it be embarrassing if the Fed had to make one of the biggest emergency rate cuts ever because of some rogue trader?"

Granted, fears of a recession in the United States and continuing worries about the spread of the subprime mortgage collapse were also responsible for the market downdraft in the last 10 days. But Mr. Ritholtz argued the rapid move by Societe Generale to close out tens of billions in futures positions might have been a major factor in pushing an already nervous market into an outright panic.

That last sentence is key. Whatever the rogue trader might have added to the panic, the market was already quite "nervous" well in advance of his actions. For Mr. Ritholtz to suggest or imply that the Federal Reserve was only responding to the actions of one trader is simply not supported by the facts.

As with most conspiracy-mongering, especially when it comes to the Federal Reserve, there was not a "lone conspiracy theorist." The Times tells us of at least one other:

Mr. Ritholtz is not alone in his suspicions. "I definitely think there is a link," said Byron R. Wien, chief investment strategist at Pequot Capital Management and a 40-year Wall Street veteran. "This precipitous unwinding created the negative momentum that spread around the world."

Mr. Wien also singled out the Federal Reserve chairman, Ben S. Bernanke, for criticism. "Bernanke has been reacting to events, rather than anticipating them," he said.

I see... Mr. Wien actually believes or wants us to believe that the Federal Reserve should have anticipated the actions of this rogue trader. That is a completely laughable proposition. Even as a general proposition it completely false, but this is why we hear such chattering on Wall Street about the Fed being "behind the curve." The Fed sees its charter as to respond to events (such as the collapse of an asset bubble), while a bunch of renegades on Wall Street feel that this charter is wrong and that the Fed is supposed to prevent market activity to try to force the markets to always adhere to principles that these renegades decide for themselves. The renegades think a recession is already baked in the cake and want the Fed to act as if that were fact. The Fed clearly believes that is not the case and has set policy accordingly. But, the Fed also has to cope with the potential economic impact of market events as well. Mr. Wien's criticism is completely off the mark. To be clear, his firm is in fact a hedge fund. Sane people should never look to hedge funds for reasonable assessments of Federal Reserve policy.

To be clear, the Federal Reserve is not responsible for assuring in advance that markets follow imagined rules that Wall Street "professionals" contrive, but rather the Federal Reserve works best to stay out of the markets in general and only intervene when a market disruption rises to the level of being a systemic threat to overall financial markets or the overall economy.

Enough on that aspect of this matter.

What really bothers me is that this episode demonstrates the folly of "banks" being able to trade for the house account, so-called proprietary trading or the operation of a so-called proprietary trading desk. Sure, proprietary trading is a great profit center for banks (accept at times such as this), but it is completely inconsistent with the charter of banks and financial institutions in general. If a bank wants to be a bank, it should stick to banking. If a so-called bank wants to engage in betting on market outcomes, then the so-called bank should change its designation to an investment fund, and notify shareholders of that fact.

What bothers me even more is that the proprietary trading desk is free to take positions that are counter to the interests of the bank's customers to whom the bank has a fiduciary duty to act as a rock-solid financial institution.

Put simply, proprietary trading is an extreme distraction which requires a level of management attention that distracts from the bank's main business of... banking.

And as this episode illustrates, management of proprietary trading is fraught with risks. The last thing that banking customers need is for the management structure of the bank to be swiss-cheesed with managers whose specialty is something other than providing the highest quality banking services to its customers.

Now, if only I could figure out a way to get the media to shine a spotlight on the lunacy of allowing proprietary trading within banks.

Sigh.

-- Jack Krupansky