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A Rogue to the Rescue: UBS Scandal Reinforces Need for Strict Volcker Rule

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As a draft of the Volcker rule has made the rounds in the last several weeks, it has alternatively caused fits of despair and cries of exultation. And that’s just among the proponents of the regulation.

Then came news that the Swiss bank UBS lost $2.3 billion thanks to a rogue trader. Of course, it’s terrible for the bank, and the last thing we need right now is another fragile financial institution. But for Volckerites, the timing couldn’t be better. It comes just when the rule’s champions are trying to preserve the draft’s strongest measures and buttress the weaker clauses.

Such is the perpetual state of emotional confusion these days for believers in banking reform and other hopeless pessimists. It’s satisfying to be right about the risks. But that is overwhelmed by the horror of seeing their predictions about the instability of the global financial system come true.

Regulators have been toiling away to write the specific provisions of the Volcker rule, which is intended to prevent banks trading for their own account and is named after Paul A. Volker, the former chairman of the Federal Reserve. The rule was a back-door and second-best way of re-instating Glass-Steagall, the Depression-era law that separated commercial banking with its mom-and-pop depositors from investment banking with its reckless traders.

Turns out that bank lobbyists didn’t just fall off the turnip truck. They knew the consequences a robust rule would have and went to work in the arcane and shadowy rule-making process to carve out exceptions that you could drive trucks through, turnip or Mack.

Reports about the draft show how confused even the architects and close observers of the regulation are. The Wall Street Journal suggested that the draft contained such huge loopholes about what banks could label hedging that traders would “have license to do pretty much anything,” according to Robert Litan of the Kauffman Foundation.

By contrast, a Bloomberg article this week suggested that the rule might limit reckless speculation by overhauling the way traders are compensated to base their pay on the fees banks charge for the products they create, rather than on the profits generated by trading positions based on those products.

Then there is the exception for market making. Banks are allowed, under the Volcker rule, to take positions in securities and other investments to help facilitate smooth trading. But the banks need to hedge that exposure as best as they can.

Of course no hedge is perfect. That allows a trader, who might think he knows more than a client, to shade his hedge a little bit one way or another. After all, if he’s right, the bank makes more profit. More profit means higher bonuses (under the current way of doing business).

Allowing the market-making exception could leave a gaping hole in the law. The former banker and author Satyajit Das, who has a new critical book about finance called "Extreme Money: Masters of the Universe and the Cult of Risk” (FT Press), says that proprietary trading has simply moved over to market-making desks. He told me that he was recently consulting with a bank when a lawyer in the room said, “With that exception, I’d be embarrassed if I couldn’t excuse a trade.”

Which brings us to UBS’s Kweku Adoboli and his perfectly timed blowup.

Mr. Adoboli was apparently trading in the service of clients, which traditionally is thought of as market making. He was, according to a person familiar with the trading, working in an area of the bank that structured equity trades for clients—say, an investment that mimics the performance of a group of European stock market indexes. And he was supposed to hedge the bank’s positions.

So far, that’s OK. Banks are allowed, under the Volcker rule, to serve clients and make markets, and they are supposed to hedge.

UBS says that the Volcker rule has nothing to do with Mr. Adoboli’s situation. “The Volcker rule was intended to address perceived risks with banks’ proprietary trading activities, not the type of alleged fraudulent activity (which is subject to criminal investigation) recently uncovered at UBS’s trading desk in London. That is a very important distinction,” a spokesman said.

Sure, fraud is fraud.

But it’s a bit more complex than that. As drafted, the rule has an interesting clause. Permitted market-making activities cannot involve “high-risk” assets or trading strategies. The draft language defines this as an asset or a trading strategy that would “significantly increase the likelihood that the banking entity would incur a substantial banking loss or would fail.”

So, was this “high risk”? Almost anyone on Wall Street would say this is plain-vanilla stuff.

Yet the bank lost billions, its stock took a hit and the chief executive walked the plank. Seems to qualify as high risk to me. Either that, or even plain-vanilla trading is too prone to blowups for comfort.

It’s all the more so when traders are compensated for gains in their trading. Mr. Adoboli doesn’t appear to have made any illicit money directly from his scheme. Nor did Jérôme Kerviel, the Société Générale rogue trader.

But illegal money is not the motivation. Traders on market-making desks are often paid handsomely in a manner indistinguishable from prop traders—by bonuses based on how much profit they make the bank. Mr. Adoboli was a lower-level employee at UBS. Such employees have an incentive to try to take more risk because when they make more, they get bonuses and their bosses get bigger bonuses.

The draft of the Volcker rule has language to address this issue. Regulators can look to see if the compensation looks more like that of prop traders as a signal that yes, walking and talking like a duck does make one a duck.

So, supporters of the Volcker rule again get to feel their patented mix of contentment and trepidation. The good news is that tough language is in there. And UBS has reminded all of us (as if we needed it) why such strict rules are needed.

Now the moment of unease: Given these powers, will regulators use them?

Jesse Eisinger will appear with former New York Gov. Eliot Spitzer and ProPublica reporter Jake Bernstein on Oct. 11 at the Tenement Museum to discuss financial reform and the financial crisis. For more information, visit http://www.propublica.org/events.

What does some trader fraudulently entering trades - deceiving his own firm’s risk department - have to do with the Volker rule? This article is silly. There’s a problem with the firm’s risk systems - clearly - but it’s weak writing/thinking to make it about something that it isn’t.

Catherine Tripp

Sep. 28, 2011, 8:42 p.m.

The American Banker’s Association is an extremely powerful lobbying group.  When Bank of America acquired Merrill Lynch, I remarked that banks have never been motivated to increase the wealth of their clients, as a matter of fact, with fees and interest and transactional add-ons, their profit plans do not reward customers for doing business with them.  Merrill Lynch is a stock brokerage - when they merge, believe nothing.  No way should bankers be brokers.  There’s something baaaaad happening in Oz.  They should not be allowed to play such high stakes games with OPM (Other People’s Money).

BJS,

No trading by the bank, no trading loss. Seems simple enough to me.

Based on what I’ve read, Bjs is correct - this incident would not have been prevented by the Volcker rule. The Volcker rule permits market-making trades, which I believe is what the trader was supposed to be making.  The trader circumvented (weak) risk controls to make unhedged trades.

There’s only one way to stop this.  Average people need to take their money off the craps tables and put it in local credit unions, and community banks, then watch it closely.

I disagree that “the last thing we need right now is another fragile financial institution.”  A few more and people might finally realize what Catherine and Nancy are saying:  Customers are tools for banks, not masters.  A few legislators might realize that bailing them out is money flushed down a (pay-)toilet.

Additionally, as Bjs points out, what Adoboli did was already illegal.  Invoking the Volcker Rule would mean, what, he might get a formal reprimand from the boss before going to jail for fraud?  His coworkers will be obligated to shun him?  It’s like passing a no-murder rule at the office.

The right regulation is that you can’t insure/hedge against (or for) anything beyond your actual position in the market.  That is, if you don’t actually own barrels of oil, you shouldn’t be able to take out insurance against the price of oil dropping.  Because again, that’s blatant fraud.

This lets businesses hedge against rising costs of raw materials and investors to remove some risk from their portfolio without turning the economy into a (Russian?) roulette game.

I’d be fine with glass steigel or volcker rule so long as my money is on the safe side of the fence and so long as tax payers in no way subsidize the risky side. I say let investment banks enter all the risky trades they want and let them suffer the consequences. The real problem is the public is not engaged. There never should have been any bailout. I think it was Sen. Dodd who was chairman of Senate Banking in ‘99 when financial dereg. was permitted. Why he still has a job is testament to the real problem: special interest money and public ignorance

Jesse Eisinger

About The Trade

In this column, co-published with New York Times' DealBook, I monitor the financial markets to hold companies, executives and government officials accountable for their actions. Tips? Praise? Contact me at .(JavaScript must be enabled to view this email address)