DODGING DODD

Our Hero was pretty good today. He was pleasant, prepared, amusing and knowledgeable in discussing the brave new world of finance in testimony before the Senate Finance Committee. So give credit where credit is due unlike the administration's proposals which will probably have the effect of reducing credit where ever it is needed. This show is going to play for a long time up on the Hill so I thought I might try to break down some of the salient points regarding banking and regulation and go over some of the issues we have already discussed in light of the proposed regulatory framework.

What Our Hero and our Man in Waiting, Larry Summers have been emphasizing is the all encompassing desire to reduce leverage and add capital within the system. You know my views in regard to capital as it pertains to banks: it's a regulatory myth unless one removes for once and for all the concept of too big to fail. As what is being proposed is a regulator for those institutions that present a systemic risk--as yet to be identified--by definition the concept of increased capital adequacy is crap. The word has already gone forth to a new generation of bankers that we are going to try in the future to keep you out of trouble but in the end will will bail you out if we fail in that goal, and of course, as of yet, we have no idea how to do that. So, dismissing capital as a concept we move on to leverage which is defined as total assets multiple of capitalwhich we have already decided is not real important anyway.

The new concept in this game that everyone has glomed onto is trading for one's own account. Simply explained this means putting capital at risk irrespective of carrying out the wishes of a client in an attempt to make money in market operations. No lesser a person that my hero Paul Volker has mused that institutions that accept deposits from the public should not be able to trade for their own account. Behind all this is the theory that if this is allowed to occur an institution will gear (leverage) itself up to maximize volume and therefore, profits. So therefore, let us have strict gearing ratios. True. Now for the real world.

In the real world, An institution that may have a balance sheet with total footings at the end of a month or of a quarter or of a year of, say $1 trillion, might well look a good deal different in the middle of any of those periods. Indeed, those footings may be double in the middle of any week. This is a result of trading that occurs--yes, for one's own book but also as a result of customer operations that cause the institution to hold positions in order to best service customers or the market. Remember our discussion of what is a market maker? If you are one...and by the by a Primary Dealer in U.S. treasury securities is a market maker...you have to be prepared with a bid AND an offered price on the instrument in which you make a market. By the very nature of the business a market maker does not always have the luxury of ending the day square in its position or always within the limits of its gearing ratio. Further, financial institutions often take advantage of movements within a market place that cry out for a large position and for periods of time their gearing may be well above a "safe" limit. Keep in mind that profit and loss in trading operations is measured as a result of tiny movements in price, and hence, one must deal in "size" as the traders like to say to show meaningful results. However, it is important to note that positions such as this are mostly short in nature and profit and loss PARAMETERS can be more or less accurately defined. A regulator could of course, require an institution to report its gearing on a daily basis but the difficulty in so doing given the 24 hour nature of today's market place might well make such an exercise meaningless as well as to simply add an unacceptable degree of volatility as positions would be essentially "day traded." In any case, it was not the gearing of "systemic institutions" that caused the problem of the past 9 months but the very nature of the products created and the misunderstanding within the system of their distribution that in no little manner was was exacerbated by some of the regulation in place that was designed to protect the system. Confused yet? Well it gets worse. Tune in tomorrow as we explore who did what to whom and the elephant in the room that somehow remains unmentioned.