PHILADELPHIA (MNI) – In a speech at a Global Interdependence Center
conference Tuesday, Kansas City Federal Reserve President Thomas Hoenig
repeated his call for commercial banks to be restricted to their core
lending activities. He argued that the risks associated with dealing,
market making and proprietary trading are difficult to assess, monitor
or control.
Hoenig also proposed changes to the rules for money market funds
and repo instruments — such as eliminating the automatic stay exemption
for mortgage-related repo collateral — that he said would increase the
stability of the shadow banking system “because term lending would be
less dependent on ‘demandable’ funding and more reliant on term funding,
and the pricing of risk would reflect the actual risk incurred.”
The following is the first part of excerpts from his speech:
Proposal to Reduce Costs and Risks to the Safety Net and Financial
System
Let me turn briefly to the reforms that I judge necessary if we
hope to more successfully manage the risks and costs to the safety net
and financial system. First, banking organizations that have access to
the safety net should be restricted to the core activities of making
loans and taking deposits and to other activities that do not
significantly impede the market, bank management and bank supervisors in
assessing, monitoring and controlling bank risk-taking. However, these
actions alone would provide limited benefits if the newly restricted
activities migrate to shadow banks without that sector also being
reformed. Thus, we also will need to affect behavior within the shadow
banking system through reforms of money market funds and the repo
market.
Restricting activities of banking organizations
The financial activities of commercial, investment and shadow banks
can be categorized into the following six groups1
– Commercial banking: deposit-taking and lending to individuals and
businesses. :
– Investment banking: underwriting securities (stocks and bonds)
and advisory services.
– Asset and wealth management services: managing assets for
individuals and institutions.
– Intermediation as dealers and market makers: securities, repo and
over-the-counter (OTC) derivatives.
– Brokerage services: retail, professional investors and hedge
funds (prime brokerage).
– Proprietary trading: trading for own account, internal hedge
funds, private equity funds, and holding unhedged securities and
derivatives.
Based on the criterion that permissible activities should not
significantly impede the market, bank management and the supervisory
authorities in assessing, monitoring and controlling bank risk-taking,
banking organizations should be allowed to conduct only the following
activities: commercial banking, underwriting securities and advisory
services, and asset and wealth management services. Underwriting,
advisory, and asset and wealth management services are mostly fee-based
services that do not put much of a firm’s capital at risk. In addition,
asset and wealth management services are similar to the trust services
that have always been allowable for banks.
In contrast, the other three categories of activities dealing and
market making, brokerage, and proprietary trading extend the safety
net and yet do not have much in common with core banking services.
Within the protection of the safety net, they create risks that are
difficult to assess, monitor or control. Thus, banking organizations
would not be allowed to do trading, either proprietary or for customers,
or make markets because such activity requires the ability to do
trading. In addition, allowing customer but not proprietary trading
would make it easy to game the system by “concealing” proprietary
trading as part of the inventory necessary to conduct customer trading.
Also, prime brokerage services not only require the ability to conduct
trading activities, but also essentially allow companies to finance
their activities with highly unstable uninsured “deposits.” This
combination of factors, as we have recently witnessed, leads to unstable
markets and government bailouts.
The proposed activity restrictions will enable and require bank
management to focus their activities on the traditional banking business
and manage their exposure to risks inherent in these activities. Banking
is based on a long-term customer relationship where the interests of the
bank and customer are more aligned. Both the bank and loan customers
benefit if borrowers do well and are able to pay off their loans. In
contrast, as shown only too clearly with this recent crisis, trading is
an adversarial zero-sum game — the trader’s gains are the losses of the
counterparty, who is oftentimes the customer. Also, for those firms with
access to the safety net and large amounts of credit, the advantage in
the game goes to them. Thus, restricting these activities removes a
conflict of interest between a bank and its customers, which encourages
a more stable financial environment.
In addition, the inherent riskiness of securities trading, dealing
and market-making attracts, and in fact requires, people who are
predisposed to taking short-term risks rather than lenders with a
long-term outlook. The combination of securities and commercial banking
activities in a single organization provides opportunities for the
senior management and boards of directors to be increasingly influenced
by individuals with a short-term perspective. As a result, the increased
propensity of these corporate leaders to take high risks for short-term
gain leads to more of a short-term-returns culture throughout the
organization.
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** Market News International **
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