The Comedy and the Tragedy of Banking Under Dodd-Frank

The talk around Wall Street is that profits at the trading desks of the big banks are down and that regulations are to blame.

There may be some truth to that, at least to the extent that transparency rules have deterred some price gouging. We should be careful about reading too much into the effects of regulation, though. The banks want to spin a story that regulations have forced them to tighten belts and avoid risks. They certainly do not want further regulation and would love nothing better than to roll back regulations that exist.

When listening to the bankers’ complaints, we should remember Queen Gertrude’s observation in Hamlet — “the lady doth protesteth too much, methinks.”

The largest pressure on trading profit is simply the market cycle.

Keep in mind how speculative (or information) traders make money. They take advantage of their analytical skills and superior information to pick off others in the market when prices are, in their informed view, out of whack. They like markets where prices move around frequently and in large amounts. Using a radio wave as a metaphor, they like it when there is high frequency and, even more, high amplitude. They like market price volatility because it offers them the most return on the money they put at risk in the markets. Of course, they have to be right when they bet on their superior information, but there has never been a trader that was lacking in self-confidence.

In recent months, the stock market has been up and bond rates have been stable and declining, meaning bond prices have been increasing. That sounds like good news for investors and it is. But, for the banks, all that glitters is not gold. The low volatility of prices has been terrible news for the trading desks. Whenever a news report claims that the traders’ $5000 suits are tattered and torn because of the oppressive regulations, it may just be that the reporter is taking the word of the banks whose lobbyists are using the news to influence policy.

There are two ways that bank trading has been affected by regulation.

First is that the banks have to set aside money to cover risks according to rules set by regulators. That is to say, they have to have more capital backing trading. Capital does not come free of cost, so trading is more expensive. Superficially, one would conclude that trading profits would be affected negatively. Yet for many items traded, such as derivatives, it really matters who is on the other side of a trade. Banks will still be the preferred counterparty. One must expect that the “spreads” that are charged by banks to customers will just go up so that the costs will be passed on. The big banks will still do their business with customers at the same profit levels since they are all in the same boat. There are a number of other indirect costs of regulatory compliance, and the results are likely to be the same.

The other effect of regulation is outright prohibition of specific trading activities. The Volcker Rule, which prohibits certain kinds of trading altogether, is the primary example. It remains to be seen just how effective these prohibitions will be. The rules need to be put into effect and enforcement must commence before any conclusion can be drawn.

But we do know that, right now, the banks are bigger and more concentrated than ever. That is the important data point. Increasingly, academics and knowledgeable observers are arriving at a consensus that the sheer size of the financial sector is a major drag on our economy. Certainly, the financial sector provides an essential service as the facilitator of investment in beneficial activities. But it is also clear that a financial sector that is larger and more complex than that which is needed induces investment in activities that are not beneficial. Even the New York Times has featured this newly appreciated truth as a breakthrough.  

We at Demos have been at the vanguard of this consensus. We have demonstrated how the excessively large financial system is at the very heart of the transformation of the US economy into something approaching a zero-sum game between financial wealth-holders and the rest of America. Because of the oversized financial sector, everyone else is poorer when the wealthy become wealthier. Indeed, we argue that financialization is not only a major driver of growing inequality but also undermines key sources of growth and job creation.

All of the regulations that have been (questionably) blamed for falling trading profits are designed to protect banks (and, by extension, the public) from themselves. Even the Volcker Rule is premised on the assumption that the prohibited trading is too inherently risky to be tolerated. The new way of viewing the financial sector goes well beyond the fear of another crisis and calls for types of regulation that are not even addressed in the Dodd-Frank Act.

The thought of taking on the banks must be harrowing for politicians, but the damage done by an over-large financial sector is great indeed. “Our doubts are traitors, and make us lose the good we oft might win, by fearing to attempt"

If regulation has caused trading to be less profitable, that will be good for the vast majority of Americans. It is doubtful that it has. The problem is that the effects of regulation have been inflated in the hopes that the targeted audience will miss the truth, that a shrinking financial sector would be a good thing. Policy makers must resist the lamentations of the bankers and remember one thing: Even "the devil can cite Scripture for his purpose"