In-house proprietary trading at the big banks is a HUGE evil

I have lost count of how many years I have been ranting about the evils of in-house proprietary trading at the big banks (and formerly brokerage firms.) Now I find out that there in fact is a second person in the world who believes how evil that proprietary trading is: Jeremy Grantham. I traditionally have not been a fan of his. He is way too bearish and cynical for my taste. Still, I do like to read quotes from him and even an occasional piece that finds its way into the public domain. I actually enjoy sifting "signal" from "noise" and find that no matter how far off a piece is, usually there are some useful tidbits in there somewhere. To wit, John Mauldin just emailed out an Outside the Box E-Letter entitled "Just Deserts and Markets Being Silly Again" by Mr Grantham. I didn't find most of the piece very enlightening, but when he finally got around to recommending some reforms for our shaky financial system, his "Step 1" immediately caught my attention. he must have been reading my mind.

I agree with his starting point: "Proprietary trading by banks has become by degrees over recent years an egregious conflict of interest with their clients." Actually this conflict of interest has existed for many, many years, but in recent years it became a HUGE problem.

I also strongly endorse his thesis that: "Prop trading can easily introduce an aggressive hedge-fund type mentality into the very hearts of what ideally should be conservative, prudent - even boring - banks. This hedge fund mentality became a dominant organizing principle, particularly with respect to compensation practices. It encouraged personal aspirations over corporate goals and invited bonus-directed behavior at the clients' expense and ultimately, as we have seen, at the taxpayers' expense to rid itself of this problem."

In short, in-house proprietary trading has focused management on "easy money, fast money", and that "easy money, fast money" is not a solid foundation for what the rest of us call "banking." As Mr. Grantham suggests, this is "an aggressive hedge-fund type mentality" which put simply, has no place in what we all call "banking."

Here is the passage which I 100% agree with (and have for a number of years):

Step 1 should be to ban or spin off that part of the trading of the bank's own money that has become an aggressive hedge fund. Proprietary trading by banks has become by degrees over recent years an egregious conflict of interest with their clients. Most if not all banks that prop trade now gather information from their institutional clients and exploit it. In complete contrast, 30 years ago, Goldman Sachs, for example, would never, ever have traded against its clients. How quaint that scrupulousness now seems. Indeed, from, say, 1935 to 1980, any banker who suggested such behavior would have been fired as both unprincipled and a threat to the partners' money. I, for one, saw Goldman in my early days as a surprisingly ethical firm, at worst "long-term greedy." (This steady loss of the old partnership ethic is typically underplayed in descriptions of Goldman.) Today, Goldman represents a potential hedge fund trade as being attractive precisely because they themselves have already chosen to do it. These days, all - or almost all - large banks do proprietary trading that is pure hedge fund in nature. Indeed the largest bank, Citi (owned by us taxpayers), is gearing up to substantially increase its aggressive prop trading as I write. ("No, no, we're not!")

Some insiders have argued that we should not worry about prop trading because they claim it did not play an important part in the recent crisis. I think this is completely wrong for it misses the very big picture. Prop trading can easily introduce an aggressive hedge-fund type mentality into the very hearts of what ideally should be conservative, prudent - even boring - banks. This hedge fund mentality became a dominant organizing principle, particularly with respect to compensation practices. It encouraged personal aspirations over corporate goals and invited bonus-directed behavior at the clients' expense and ultimately, as we have seen, at the taxpayers' expense to rid itself of this problem. All Congress has to overcome is the lobbying power and campaign contributions of the finance industry itself, which I admit is no small feat. In a bank with a hedge fund heart, you can't reasonably expect ethical or non-greedy behavior, and you haven't seen it.

Of course, commercial and investment banks need to invest their own capital. They probably should have the right to do genuine hedging against investments that flow naturally from their banking business. As for the rest, they could easily be required either to limit the leverage used on prop desk trading or to be restricted to investing in government paper and, at the very least, play by the same rules as other hedge funds. What they certainly should insurance, as is now the case.

In the early 1930s, following the famous Pecora hearings, the conflict of interest between the management of other people's money as fiduciary and the business of dealing and underwriting in securities was considered so inimical to the public interest that Congress almost compelled separation of proprietary trading and client trading. Close, but no cigar. Instead, Glass-Steagall made the probably less useful step of separating commercial and investment banking. Unfortunately, they left intact the obvious conflict between the banks' managing their own money and simultaneously that of their clients. We now have a unique opportunity to revisit this matter.

(As we ponder the problem of prop trading, let us consider Goldman's stunning $3 billion second quarter profit. It appeared to be almost all hedge fund trading. Be aware also that this $3 billion is net of about $6 billion reserved for future bonuses. Goldman's CEO had, in fact, the interesting job of deciding how much of this $9 billion profit would be arbitrarily awarded to shareholders. [In this case, one-third. Could be worse!] This means that they extracted every penny of $9 billion from a fragile financial system. "Good for them," you may say, and they indeed are very smart. But surely they should not have been insured against failure by us taxpayers! Remember, they are now also a commercial bank yet very, very little of their $9 billion came from making loans. Three months later their bonus pool for the year is estimated to be a new record at $29 billion. And the whole banking industry is back to a new record for remuneration. How resilient! How remarkable! How basically undesirable for our economy!)

...

The separation of commercial banking from investment banking is not as vital as the removal of prop desk complicated enterprises both smaller and simpler, which characteristics I for one believe are probably essential if we are to avoid further disasters.

In summary, I wholeheartedly agree that the problem was not the combination of commercial and investment banking per se, but the existence of in-house proprietary trading (in conflict with customers) in any banking organization. The corrolary is that re-separating commercial and investment banking is not the solution per se, since it is the in-house proprietary trading that is the systemic threat.

Of course, there is no way that the big financial institutions would relinquish such a huge source of profits. But the simple truth is that the sheer level of these profits is a direct indicator of the level of conflicts of interest, both with their customers, and with consumers all around the world. These profits are essentially a hidden tax on every citizen everywhere, with no services delivered in return for the bargain.

Well, okay, maybe we do get "Free Checking" accounts in return (and the banks then turn around and use our cash to fund their in-house proprietary trading rather than making meaningful and productive loans!), but that is not a very attractive bargain considering the vast costs to all citizens of bailing out these monsters combined with their ongoing draining of productive assets from the real economy.

-- Jack Krupansky