It's Time For "Banks" to Stop High-Risk Trading

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When members of the Senate Banking Committee recently asked Paul A. Volcker how regulators would identify banks engaged in excessive, high-risk trading, the former U.S. Federal Reserve chairman quipped:  "It's like pornography – you know it when you see it."

Volcker wants to make it illegal for banks to engage in such high-risk activities as "proprietary trading" – when an institution trades for its own accounts, as opposed to making trades for customer accounts. But as Volcker's comment illustrates, the proposal – known as "Volcker's Rule" – the whole concept of high-risk trading is pretty hazy and hard to define.

Just as hazy is the definition of what now constitutes a bank.

Long gone are the elegant subtleties of form and finesse that once defined the bank. In recent years, the entire concept has been cheapened by the vulgar obviousness of grossly enhanced compensation schemes.

No company better embodies this transformation than Goldman Sachs.

I used to be a great admirer of Goldman Sachs when it was a private partnership. Now I just gawk at Goldman like an adolescent boy mesmerized by cheap pornography.

The bottom line is that Goldman Sachs Group Inc. (NYSE: GS) has become the centerfold for everything that's now wrong with banking.

So before the truth about the sordid state of banking gets dressed up and legitimized by the usual nexus of Wall Street and Washington pimps and panderers, we would do well to strip Goldman of its cloak of invincibility and lay bare the danger in its lust for money.

Let's be clear: Goldman Sachs is not really a bank.

A commercial bank takes in deposits, offers checking and savings accounts, and makes loans. Goldman doesn't provide those services.

The Transformation of Goldman Sachs

For 141 years, Goldman Sachs was an investment bank. But that changed on Sept. 21, 2008. Goldman had reached a critical point in the financial crisis, was facing a potential collapse, and needed government help.

Since only chartered commercial banks and "bank holding companies" can access the Federal Reserve's discount window for billions of dollars worth of cheap loans, Goldman begged to be converted to a bank holding company. The approval process usually takes months to complete – and the application can be denied. In Goldman's case, however, the process took only one day. The approval was granted on a Sunday, no less.

As a bank, Goldman could now borrow untold billions from the Fed's discount window. How much? No one knows because the Fed does not disclose how much any individual bank borrows from its discount window. The new charter also allowed Goldman to sell $28 billion of debt backed by the Federal Deposit Insurance Corp. (FDIC). Goldman also got $10 billion of Troubled Asset Relief Program (TARP) money, which it recently repaid.

In addition, at the time of the crisis, Goldman was receiving collateral, in the form of billions of dollars in cash, from insurance giant American International Group Inc. (NYSE: AIG). AIG had sold credit default swaps (CDS) to Goldman to protect the investment bank from falling credit default obligations, which Goldman had gambled on. Thanks to taxpayers, Goldman eventually got 100% of the value of the CDOs that AIG had insured, even though those they were nowhere near worthless.

And what did Goldman Sachs do with all the money it got from taxpayers? It traded. That's what Goldman Sachs does – it trades.

Goldman Sachs is giant hedge fund, not a bank. More precisely, it's like a fund of funds. It has multiple "profit centers," each with its own profit-and-loss statements. Each profit center is run like a hedge fund, securitizing asset pools, syndicating leveraged loans, writing credit default swaps, trading equities, bonds, commodities, currencies, real estate – or anything else it can make a profit on – and managing money for others, by trading for them.

 Goldman Sachs is still an investment bank.

Goldman's investment-banking business is very lucrative. But the advice the investment-banking business sells for exorbitant fees is really just another means by which the firm can garner trading opportunities for itself. It manages the securities underwritings and bond offerings its investment bankers bring in from the giant corporations who are Goldman's customers. And then, of course, it trades all the instruments it creates for those customers.

Somehow, all the inside knowledge about deals, mergers, underwritings and the firm's banking business is separated from all the traders by a "Chinese wall."  But a Chinese wall isn't a real wall.

It's an illusion.

It's All About Trading

There's nothing wrong with trading, or with taking on risk to make money. But there is a problem with risk-taking with money that really belongs to depositors, or to taxpayers. There is a problem with taking risks backed by taxpayer bailouts, with taking risks that leverage the hugely integrated worldwide financial system, with taking risks that ultimately hold the world's central banks hostage.

The kind of trading that is a problem is commonly called "proprietary trading." Prop trading is trading done on behalf of the "bank" and not its customers. In other words, the bank's traders use the bank's money to take risks by positioning themselves in trades they hope to profit from. The line between the bank's money and its depositors' money – or the money made available by taxpayers to bail out the bank if its trading losses jeopardize the banks' depositors or the banking system – is a thin and hotly debated one.

That brings us back to Volcker.

Right now, the $64 million question being asked is this: How, exactly, do you define proprietary trading? Volker, the esteemed former Fed chairman who is now the Obama administration's point man on financial reform, was asked that very question last week in hearings conducted by U.S. senators Christopher J. Dodd, D-Col., and Richard Shelby, R-Ala.

We already know how Volcker responded.

This focus on defining precisely what constitutes proprietary trading is nothing more than a ruse by the cabal of Wall Street and Washington interests who want to preserve the status quo of banking and trading institutions.

While it should be clear what is or isn't proprietary trading, the reality is that it isn't clear at all. And it isn't clear precisely because everyone engaged in it is trying to hide it. Why? Because that's where the fat profits come for to pay the giant bonuses.
It's another paper thin Chinese wall, only this one is actually transparent if you look at it from the perspective of what's really going on. Banks say that they have to trade in order to accommodate their customers. Because they are so altruistic, banks will take unnecessary risks to take the other side of a customer's trade, purely to facilitate the customer, of course. Then, they have to trade out of the position they took, hopefully for a profit. But, it seems the banks trade out of these positions quite well.

And no one trades out of them as profitably as Goldman Sachs. But, it's not proprietary or "principal" trading, just good risk management in the process of serving customers.
How does Goldman spin this web of obfuscation? According to atranscript of a call with analysts, David Viniar, Goldman's CFO, made the following comment about the firm's stellar 2009 results, which saw net revenues of $45.2 billion and net earnings of $13.4 billion.

With regard to trading to accommodate customers, Viniar said: "They need someone to provide capital to be on the other side and we are there for them. That, though, results in us taking risk and in us trading. The great bulk of what we do all day long in all our products for all our clients which hopefully helps them results in us taking risk and if we manage it well, results in us making a profit."

In other words, Goldman can take the other side of every trade a customer puts on and call it a customer-based trade it's taking, rather than a proprietary trade. There's nothing to stop them from taking the other side of a customer's trade in IBM, for that matter, and arguing that would not constitute a prop trade. But, whose capital is then at risk? Not the customer, the bank, or in this case Goldman's capital.

And here's where the rubber meets the road. Goldman is not a private partnership, whose partners' equity capital and years of prudent management are being risked on everyday bets. It's public shareholders being teed-up first, then taxpayers, then the Fed when it has to bail out the banking system (that would be taxpayers, again), then the U.S. Treasury when it has to bail out the economy (that would be the taxpayers, again), and then the world's central bankers who have to bail out countries afflicted by contagion (that would be us taxpayers, again).

It solution is really simple. Separate deposit-taking commercial banks backed by taxpayers from investment banks. End all prop trading at commercial banks. Allow them only to act in an agent capacity when they fulfill customer orders. Never backstop private risk-taking investment banks, hedge funds or private equity shops. Break up all the too-big-to-fail banks, starting with Goldman Sachs. And if any product, derivative or otherwise, is allowed to be launched after extensive academic review, make them transparent, traded and cleared through adequately capitalized and monitored exchanges.

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. Mike | February 12, 2010

    Dear Mr. Gilani,
    I'm reminded of the fable about "The Kings Clothing" as I watch this drama playout in these Congressional hearings. What no one seems to want to talk about is The Glass Steagall Act, which was removed in 1999 (some eight years before the meltdown). To me, it is as though we are holding the Pecore hearings all over again. Only this time it appears that the good Senators are trying to make game changing decisions in the 6th inning of the next market crash brought on by, basically, the same type of risky financial behavior which caused the last crash of 1929. I'm left to ask myself "what is going on here"? In those hearings one Senator asked the Treasury Secretary, if he favored the reinstatement of The Glass Steagall Act. The Treasury Secretary answered, NO and that was it. No followup question, no explanation, nothing, nada, zilch! I mean here we are on, what I believe, is the greatest financial cliff since 1929 and that is it?! Gezzz…. Perhaps several years from now, when this kind of risky behavior has caused even more damage, again, perhaps someone in authority will finally stand up and suggest that we reinstate Glass-Steagal. And for another 70 years we can return to financial sanity and all will, once again, be fine in our fair kingdom. That is, until the financial wolves come calling again… Perhaps next time, we will remember the damage they caused during their last visit and we will shoot them. Or perhaps Mr. Kondrotiev was right after all……
    Mike

    • FREDDY SMITH | February 27, 2010

      IN CHINA, UNDER CHINES LAW, SUCH WOLVES ARE USUALLY SHOT IN FRONT OF A FIRING SQUAD. AND THE COST OF THE BULLETS PAID BY THEIR IMMEDIATE FAMILY.

  2. Frank Wilkinson | February 12, 2010

    Outstanding article on a big problem. This information needs to be made available to the media and particularly to the administration. Paul Volker was one of the best Fed Chairman we have ever had. I hope the administration pays attention to his recommendations. If not, we will see another financial disaster in a few years. Designating Goldman Sachs as a commercial bank is a bad joke.

  3. Ronnie Bauch | February 12, 2010

    This article finally answers the question that the media and government officials should have been asking at least for a couple of months: how did Goldman Sachs make all that money in this pitiful economic climate? It also answers the unarticulated question of how could the stock market rise 53% from its 2009 bottom, given the current (and likely future) economic situation. In other words, where would the DJI be if it accurately reflected the current and future economy instead of being masked by all this trading using Fed money? The answer would probably be a lot closer to 2,000 than 10,000. Pres. Obama and some of the Congress has finally figured this out (probably thanks to Mr. Volcker). Make your plans accordingly.

  4. Tom Stiebler | February 12, 2010

    Dear Mr Gilani,

    To my way of thinking, the investment banks as well as fannie and freddie, AIG et al , some of their 'regulators', and much of the congress are engaged in nothing less than a gigantic criminal conspiracy. It ought to be investigated under the RICO laws.

    There is just so much sleaze in the whole picture, that I believe a determined prosecutor could find enough instances of illegal activities (bribery, illegal campaign contributions, illegal trading activities etc) to unravel the threads and blow the whole corrupt enterprise out of the water.

    And does anyone believe the monster banks which have swallowed up large regional banks like First National Bank of Chicago as if they were kril are not engaged in monopolistic business practices ?

  5. The Skeptical Cynic | February 12, 2010

    Mr or Ms (whatever the case may be) Gilani:

    Did you write piece from the rubber room at the Home of the Terminally Naive!

    Skillful, long range planning, Machiavellian machinations, the manipulation of easily-convinced-largess-in-the-form-of-with-campaign-contributions-for-a-congressperson(s)-or -the-threat-of-such-largess-going-to-a-pliant-opponent-will result in some legislation apparently enacted to stop the abuse but written replete with double negative phraseology, obfuscating and conflicting legalese in each paragraph with its "striking here', "and inserting here", "amending" there all of which render the purpose "short statement of the legislation" null, void and of no effect. (Oh, I almost forgot, and which more than 90% of congresspersons will never read.)

    In a year in which the nation as a whole "tanked", unemployment reached double digits, the nation is still faced deficits the likes of which a great many Americans have never seen before and but in which Goldman Sachs has NET EARNINGS of $13,400,000,000.00, you cannot be serious to suggest that with that kind of lucre "on the table" that Goldman Sachs does not have a scheme to keep "milking that cow", placating the golden egg laying goose at the expense of 90+% of the population.

  6. Bob Weir | February 12, 2010

    Most revealing. I never knew. I wonder, though, if Goldman engaged in these kinds activities, or took these kinds of risks, etc, when it was private.

  7. Matt | February 12, 2010

    This is a great article that shows the impossibility of effective regulation. Even the regulators can't define 'prop trading'. Despite the good intentions, this kind of regulation will only make things worse for everyone (except the big banks of course who will figure out ways around it).

    Great conclusion; I only wish it was higher up in the article. We need to end the bailouts and stop the government from guaranteeing big banks with hard-earned taxpayer money.

  8. Don Fishgrab | February 12, 2010

    Mr Giliani stated what he believes should be done. That does not imply he believes that is what will happen. Rarely does government do what should be done. Both elected officials and bureaucrats have a vested interest in maintaining the status quo.

    In New Mexico, we are told that state employees' who average $65,000 in pay and benefits cannot withstand a 2% or $1300 pay cut although their average salary is double the average for private employees in New Mexico, and $65,000 higher than that of those who have lost their jobs.

    Federal employees are in a similar situation, and have recieved huge increases of income in many cases, matched only by top bank officials during this crises. They nor the banks are willing to surrender those gains. Politicians are not willing to surrender lobbying commitments, so it is doubtful that any meaningful changes will occur, either in banking laws, or in reduced Government spending.

  9. Veracity | February 12, 2010

    In order to operate a bank account any natural person or entity needs to provide a whole bevy of documentation to thoroughly prove their identity.
    So why do we allow trading on all exchanges and markets to be conducted in complete secrecy, where corporations such as GS can take the ‘other side’ of a trade out of pure ‘benevolence’ to allow their customers to make a profit at their expense!

    Yes right!

    This is an organisation some would describe as a sordid, morally bankrupt crime syndicate whose sole purpose is, and evidently successfully so, to fleece the public of their hard earned cash by any means possible.
    Their massive size, Washington connection and ‘proprietary’ trading software allows them to not just manipulate the market, but to virtually control the markets at their will, and in the process fleece the public to the tune of some $13b annually.

    If the anonymity would be removed, then the crime would patently stop, as anyone could see who does the manipulation, and who takes the other side of their trade, recommended say by their friendly GS “client advisor”!
    It’s time to bring transparency back into the markets, where anyone can access an online register of any market, and identify any trade of any day as to who is the ultimate beneficiary of the trade, no Trusts, no untraceable fancy incorporated entities, no anonymous Nominee accounts; the true beneficiary of the trade, as is the case with bank accounts for Joe Citizen.

  10. Doug Stevens | February 13, 2010

    H E L L Ooooooooooooooooh TERM LIMITS NOW!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

  11. Jas Gill | February 14, 2010

    I hope the house and senate members that are working on financial regulatory reform have read your article. I plan to send it to my area representatives. It is very well written, understandable, should be required reading for all elected and designated officials engaged in financial and economic interests of the public.

  12. DellaTerious | February 15, 2010

    Great article, except it misses a very germane point: to rescue AIG and Bear, Goldman Sachs America, and Merrrill, various laws were broken, some by the renominated and re-appointed Benron Bernie-anke. When the economy is again staring into the abyss of meltdown, you can have any law prohibiting anything you want on the books, it will, and with impunity, be broken.

    The herd will care not a whit.

    The Bush administration's legacy of considering itself, and indeed the US above the law has ramifications that we all choose to ignore:

    the rich are above the law
    might makes right
    military is not part of the government (how else can you advocate shrinking government while constantly growing the military? You can't, unless they are two separate entities, a fact underlined by Reagan"s love of militarism yet famous "I'm from the government and I'm here to help" quip. The military is simply not thought of as the government, neither by the Pentagon nor its civilian sycophants. And if the civilian government considers itself above the law, how do you suppose that part of it with all the guns thinks of itself?).

    No. The only plan that's obvious to everyone is the coming destruction of the overbuilt productive capacity of the globe to bring it in line with the destroyed consumption demands of the developed worlds unemployable masses. To believe that this will come to pass via peaceful means is the province of the fool. The thirst for cataclysmic destruction on a global scale is palpable at even the smallest of "tea Party" gatherings, and the rumbles of mis-placed blame reminiscent of Weimar.

    No "law" restraining the activities of so-called "investment" banks is likely to change that. (Laughable that the paper they trade is still called "securities", n'est-ce pas?)

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