An Opinion On Prohibiting Banks From Engaging In Proprietary Trading (Research Paper Sample)

  What is your opinion on prohibiting banks from engaging in proprietary trading? Discuss it with specific reference to your knowledge of banks. Word Count; 2016 The author’s opinion on prohibiting banks from engaging in proprietary trading Introduction The Volcker Rule is one of the most controversial sections of the Dodd-Frank Act. The rule, which came into effect in December 2013, seeks to prohibit banks from engaging in proprietary trading (Coffee, 2011). Proprietary trading, according to Boot and Ratnovski (2013), is speculative trading of financial instruments with the aim of profiteering on short-term price movements (Usually less than six months). Merkley and Levin (2011) also further adduce that even though speculative trading is a major function of banks, the Volcker Rule sought to limit the bank buying and selling in financial instruments in its capacity as a principal. Proponents of the Rule cite a decreased systemic risk that is accustomed to reduced excessive risk-taking in banks (Lehmann, 2016; Bubb and Kahan, 2017; Omaroya, 2010; Elliot and Rauch, 2014). Further, they argue that banning proprietary trading would lead to a culture change leaning towards conservative banking that is risk-averse and more customer oriented. That notwithstanding, the Rule is not without its critics. Scholars have raised concerns about the cost and effectiveness of the ban warning that the rule may adversely affect the market liquidity, increase the cost of transactions, negatively impact the value of securities and render borrowing expensive in the future (Brunnermier and Pedersen, 2008; Morgan, 2002; Wilmarth Jr, 2010; Whitehead, 2011). This paper thus seeks to analyze the perceived benefits pros and cons of banning proprietary banking. The paper will also explore the role of banks in an economy and conclude with the author’s opinion on whether proprietary banking should be prohibited or not. Role of banks  Wilmarth (2012) defines a bank as an insured and licensed depository institution. Banks play a crucial role in the economy. One of the key functions of the bank is receiving funds from savers and allocating the same to borrowers efficiently and at a profit which is the difference between the interest charged and the interests earned (Rehlon and Nixon, 2013). In so doing, banks act as intermediaries between surplus and deficit economic agents. Another core function of banks is trading (Kroszner, 2000). Here, banks may trade financial instruments such as stocks, bonds, currencies, commodities, equities and other derivatives as financial intermediaries for their customers and sometimes in their capacity as a principal hence the term proprietary trading (Boot and Ratnovski, 2013). Trading involves speculative buying and selling of financial instruments for a profit. Other services offered by banks include risk management services, remittance of money, provision of liquidity to households and firms and promotion on entrepreneurship. Banks should be prohibited from engaging in proprietary trading This section of the paper explores the rationale for validating the prohibition of banks from engaging in proprietary trading. Generally, according to Lehmann (2016); Bubb and Kahan (2017); Omaroya (2010); Elliot and Rauch (2014), banning proprietary trading seeks to address five primary concerns being the creation of a safer banking system, cutting banks manageable and less risky sizes, reducing banks risk of default, promoting transparency and reducing the risk of fraud perpetration, and finally instituting a cultural change fostering risk averseness. To begin with, analysts believe that prohibiting banks from engaging in proprietary trading would make stand-alone organizations and the overall banking system secure. According to Manasfi (2012), the ban would safeguard banks from market risks and earnings instability hence reducing the risk of systemic failure emanating from regular shocks and contagion. Further, according to Kress (2011), systemic risk, a postulation of counterparty risk, occurs when chains of counterparties form to enter complementary transactions. It follows that the failure by a single large counterparty to honor its obligations may trigger a domino effect affecting the whole system (Bubb and Kahan 2017; Omaroya, 2010). Second, the prohibition would also reduce the size of banks making them less risky with regards to systemic risk. Lehman (2016) articulates the compulsion of the Federal Government to bail out AIG up to $85 billion using taxpayers' money during the 2008 financial crisis to avert a global financial meltdown as a result of the institution's liquidity crunch and inability to pay off its dues (Aragon and Stahan, 2012). The crisis of unwarranted risk-taking by banks through proprietary trading is also aggravated by the moral hazard that emanates from prescribed and informal government assurance. Riding under the banner of ‘too big to fail’, entities undertake risky ventures with the assurance that the taxpayers will bear much of the costs should it fail (Wilmarth, 2012). Third, barring banks from private equity and hedge fund operations straightforwardly solves a primary avenue of bank default risk. According to Ben-David, banks control up to 14 percent of Credit Default Swaps (CDS) and are the most active market players acting both as protection buyers and sellers. Accordantly, according to a 2009 survey, five banks, that is, JP Morgan Chase, Goldman Sachs, Citigroup, Morgan Stanley and Bank of America bore 96 percent of the CDS industry credit derivative risk exposure. Further, Kress (2011) asserts that one primary cause of bank failures during the recently ended financial crisis was involvement in equity trading and venture capital activities which shored up the risk of default. Thus prohibiting proprietary trading would reduce risk exposure hence stability. Next, as in the case of the USA, another concern for establishing the Volcker rule was the need for increased transparency and lower risk of fraud. Kroszner (2000) asserts that proprietary trading by banks generates a conflict of interest vis-à-vis their customers’ plight. For instance, banks would profiteer from waging against financial instruments that they had themselves created and later sold to their customers. To deter this, the rule set out to enumerate compliance provisions prompting banks to list securities and the rationale for investing in them alongside documentation of compensation schemes for dealers not linked to revenues from proprietary arrangements (Quirk, 2013). Lastly, it is imperative to end proprietary trading by banks to promote the conservative risk management culture of banks. Lehman (2016); Manasfi (2012) argue that in the absence of proprietary activities, banks would shift back to their risk-averse and client-focused culture. This would require moving or sacking risk-taking managers who are motivated by colossal compensation packages as a result of assuming risky activities. Banks should NOT be prohibited from engaging in proprietary trading There are four significant setbacks linked to the execution of the Volcker Rule being disruption of market activities, reduced diversification of bank portfolios, failure of prohibition to eliminate risk exposure and failure of the ban to address the real cause of bank failure (Brunnermier and Pedersen, 2008; Morgan, 2002; Wilmarth Jr, 2010; Whitehead, 2011). This section shall begin with exploring the benefits of proprietary trading to banks. Then, it will examine each reason and highlight its implications. Banks carry out proprietary trading to shore up their profits and diversify risk. Here, the bank acts as principals in their capacity and utilize their capital to engage in short-term speculation activities (Aragon and Strahan, 2012). A significant departure from serving as a broker and earning commissions is that the bank earns 100 percent of the profits in the trading. Further, owing to their capacity, banks can leverage better technologies such as using algorithms and other software to buy, sell and evaluate securities, something that other retailers fall short (Quirk, 2013). With the disruption of market activities, Brunnermier and Pedersen (2008) assert that banks are a major player in financial markets and thus market makers. Accordingly, prohibiting banks from engaging in proprietary activities would make them retreat hence reducing their operations. The net effect would be reducing the market capitalization on financial instruments, reducing the market liquidity, increasing transactional costs, mispricing of assets and higher risk premiums hence higher lending costs. Morgan (2002) also argues that banks hire and retain well train A class asset managers and thus prohibiting banks from engaging in trade would provide a gap for B class managers to venture hence degrading the quality trade activities. Second, banks may always need to engage in some form of trading to supplement the income from lending activities to stay afloat (Silvers and Slaykin , 2009; Morgan, 2002; Quirk, 2013). Prohibiting proprietary trading will reduce therefore reduce diversification and profitability. Although proprietary activities are highly volatile, they represent a significant part, 30 percent, of a bank's overall income (Wilmarth Jr, 2010). Proprietary activities are also a sure way of spreading risks as they are loosely linked to the primary revenue streams of an insured depository institution. Consequently, lower profits and fewer revenue streams may adversely impact on the stability of the institution. Further, other than profitability concerns, costs associated with compliance to the ban would increase operating costs hence affect the balance sheet. Such permanent costs may be associated with lower credit ratings which may require banks to borrow at higher prices (Whitehead, 2011). Third, prohibiting banks from engaging in proprietary activit...