Johnson-Stiglitz letter

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February 13, 2012

Office of the Comptroller of the Currency250 E Street SW, Mail Stop 2M3Washington. DC 20219Regs. [email protected]. Jennifer JohnsonSecretary, Board of Governors of the Federal Reserve System201hStreet and Constitution Avenue, NWWashington. DC [email protected]. Robert FeldmanExecutive Secretary, Federal Deposit Insurance Corporation050 1/u, street, NWWashington, DC [email protected]. Elizabeth M. MurphySecretary. Securities and Exchange Commission100 F Street, NEWashington. DC [email protected] A. Stawick, Secretary of the CommissionCommodity Futures Trading CommissionThree Lafayette Centre, 1155 21st Street, NW.Washington, DC [email protected]

RE: Proposed Rule to Implement Prohibitions and Restrictions on Proprietary Tradingand Certain Interests in, and Relationships with, Hedge Funds and Private Equity FundsDear Sirs and Madams:We write in response to the request for public comment on the proposed rule to implement theVolcker Rule. embodied in section 13 of the Bank Holding Company Act.'

t Federal Register. Vol. 76, No. 215, November 7.2011, pp. 68846-68972.1
mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]


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The Volcker Rule D em ands that the U .S . Financial System Be Redesigned to Serve theReal E conomyIn recent yea rs, the American m iddle class and its econ om y have been the victim of three type so f a bu se b y th e fin an cia l in du stry : u su ry , b ailo uts , a nd p ro lo ng ed to le ra nce o f d eb t o ve rh angsthat should be resolved to m ake the econom y more vita l. A ny e conom y w here financia lin te rmed ia tio n b ec omes d om in ate d b y th es e th re e a bu se s c an no t s uc ce ed in th e lo ng ru n.R ath er th an p ro vid in g th e re al e co nomy w ith th e s erv ic es a nd re so urc es it n ee ds to g row, a ne co nomy w ith a fin an cia l in du stry d om in ate d b y th e th re e a bu se s b ec omes th e mas te r o f th ere al e co nomy, in fa ct d ra in in g it o f re so urc es .W e have long b een arg uing fo r a m ore fun ctional system ', one w hich does m ore of w hat afin an cia l s ys tem is s up po se to d o - s up po rtin g th e re al e co nomy th at c re ate s jo bs , in cre as esp ro du ctiv ity , a nd ra is es liv in g s ta nd ard s - a nd le ss o f w ha t it s ho uld n ot d o - e xtra ctin gre so urc es from th e e co nomy a nd re du cin g wea lth .2T he V olcker R ule, as cra fted b y S enators Jeff M erkley an d C arl Levin, is one of the m ore potentfo rc es a va ila ble fo r a ch ie vin g p re cis ely th at g oa l: fo rc in g a re de sig n o f th e cap ita l ma rk etsa ctiv itie s o f o ur fin an cia l s ys tem s o th at th ey s up po rt th e re al e co nomy a nd m in im iz in g th e ris ko f fu tu re fin an cia l c ra sh es . In s ho rt, it d eman ds swe ep in g a nd h ea lth y c ha ng e in 'th e way o urnat ion's la rges t fin ancia l firms do business.The Volcker R ule w as drafted w ith an eye tow ards - and m ust be considered from - a system icv ie wp oin t. A t its mos t b as ic , it fo rc es a s tro ng s ep ara tio n b etw ee n h ed ge fu nd -lik e a ctiv itie s thatd ep lo y h ig h ris k in s ea rc h o f h ig h rewa rd , a nd d ep os ito ry le nd in g b an ks , w hic h s ho uld ta kemod es t ris ks to e xte nd c re dit to familie s, sma ll b us in es s, a nd th e re al e co nomy g en era lly .T he construct of th e V olcker R ule statute m anda tes a f undamen ta l r econs ide ra ti on of act iv it iesin tra din g a cc ou nts a nd o ff-b ala nc e s he et fu nd s o f b an k h old in g c ompa nie s, th e lo ci o f lo ss es inre ce nt c ra sh es , a nd th e h ea rt o f th e c omple x tra din g a ctiv itie s th at s erv ed o nly th e b on us es o fth e ba nkers, pu t taxpa yers at risk, and did not serve the real eco nom y. T he V olcker R ule forcesthe s imp lific atio n o f a nd re du ctio n o f th e tra din g a ccount a nd o ff-b ala nce sheet s tru ctu re s,e nsurin g th at th ose a ctiv itie s a re n ot embedd in g abu siv e, d ange ro us a ctiv itie s, b ut a rec on ta in ed in th eir ris k p ro file a nd s erv e c lie nt n ee ds .W e have exam ine d th e thrust of th e a rguments of those arguing again st the principles o f theV olc ke r R ule , a nd we fin d th em u np ers ua slv e, s elf-s erv in g, a nd to a la rg e e xte nt, re fu te d b yw hat has hap pened in recent years. In particular, som e have a rgue d that the V olcker R uleapproach is too com plex and w ill lim it liq uidity. T hese argum ents are a distraction. T heVolc ke r Rule will re du ce tra din g b y b an ks a nd q uite lik ely tra din g o ve ra ll. B ut q uite fra nk ly , th isis p re cis ely w ha t th e re al e co nomy n ee ds . F or in sta nc e, th e s o-c alle d liq uid ity from fla sh tra din g2 Se e JOSEPH STIGLITZ, FREE FALL: AMERICA , FREE MARKETS, AND TH E SINKING OF THE W ORLD ECONOMY( 2010 ); Robe rt J ohnson , In tro d uc tio n : M a ke M a rk ets B e M a rk ets , in R ob ert J oh ns on , E ric a P ay ne , e ds ,MAKE MARKETS BE MARKETS, ROOSEVELT INSTITUTE (2010)

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d isa pp ea re d p re cise ly w he n it w as n ee de d most. R ec en t s ch ola rsh ip h as sh own th at th ec urrent fin an cia l s ys tem , w ith its d ramatic in creas e in tra din g, is a ctually le ss e ffic ie nt th an thatof 1950 or even 1980.3 T ra din g h as b ro ug ht re co rd compen sa tio n fo r Wall S tre et tra de rs, b utth e re al e co nomy o f th e la st th irty ye ars h as n ot b ee n sim ila rly in vig ora te d. R ath er, it h as se enre al w ag es d eclin e, jo bs mov e o ve rse as, a nd th e m id dle cla ss s hrin k. T ra din g vo lume s ho uldnot be m is ta ken fo r e ffic ie nt c ap ita l ma rk ets o r p roductiv e in ve stments .To the exte nt th e V olcker R ule is to o complex, tha t is at b est a re flection of th e incre diblecomp le xity th at b an kin g itse lf h as cre ate d, a nd a t w ors t a re fle ctio n o f th e p ro po se d ru le 'stim id ity: it a ttemp ts to p ro te ct th e comp le xity o f th e sta tu s q uo a nd implement a law th at d ire cts are du ctio n o f tra din g b y b an ks w ith 'o ut re du cin g tra din g b y b an ks o r tra din g o ve ra ll. T he secon tra dictio ns m ust be re je cted . F or the U .S . to re build a he althy fin an cial system - o ne w he resa vin gs g o to p ro du ctiv e in ve stmen ts, a nd th e re tu rn s g o b ack th e in ve sto rs - th e Volck erRu le 's mandate to reduce bank in vo lv ement in c omp le x tra din g activ itie s must be imp lemen ted.N atu ra lly , b an ks a re re sista nt to th ese d emands b eca use th ey h av e ta ke n re fu ge in comp le xityto e xtra ct mass ive marg in s a nd fe es th at g en era te b on us es, w hile a vo ld in gth e h arsh su nlig ht o fcompetitio n a nd th e risk-re du cin g in ce ntive s o f th e th re at o f fa ilu re . A sh ort h isto ry le ss on w illmake th is c le ar. Decima liz atio n o f b ro ke rage c omm is sio ns in th e 1990's 'c ut in to b ro ke ragep ro fits , while th e ris e o f deriv ativ es and c omp le x in strumen ts underm ined p ro fits fromtrans pa rent ma rk ets . T he fa ll o f G la ss -S teagall a nd the deregu la tio n o f deriv ativ es mean tse cu ritie s firm s h ad to compete a ga in st b an kin g firm s, w hich h ad th e a bility to d ep lo y la rg eb alan ce she ets and d id . A t the same tim e, he dg e fu nd s like L on g-T erm C apita l M ana gemen t(LTCM ) p ro ved the immense p ro fita bility o f c omp le x tra din g s tra te gie s. a t le as t durin g c almyea rs. A s th ese tren ds cam e to ge ther, the ba nking a nd secu ritie s ind ustries - in m any cases,~ow e ffe ctive ly on e - so ug ht ou t com ple xity, op acity, an d leverag e as a m ea ns to avo id tru ec ompetitio n and p ro te ct p ro fita bility , a nd as a way to e xtra ct outs iz e p ro fits durin g norma l y ea rs ,s tu ffin g ris k in to e ve r la rger " fa t ta ils ."In ju st a few y ea rs , th e fin an ce in du stry re pla ce d clie nt-se rvic e a nd th e e xte nsio n o f liq uid ity a ndc redit w ith le ve raged p roprie ta ry pos itio ns in c omp le x a lg orithm ic tra din g s tra te gie s and c omp le xs tru ctu re d p ro du cts. T his se arch fo r "a lp ha " p ro fits d ro ve b ooms and b usts a nd re du ce d re tu rn sto in ve sto rs, in crementa lly in th e n ormal ye ars a nd sp ec ta cu la rly in th e b us t ye ars. In th en ormal ye ars, e ve ry d olla r mad e when a p ro prie ta ry tra din g o pe ra tio n fro nt-ru ns a c us tome rorde r o r othe rw ise su rfs on th e w aves of th e o rders ge ne ra ted by the ir custom ers w as a d olla rlost to pe nsio ners, m utu al fu nd s, an d o the r sa vers an d in ve stors. A nd in the bu st yea rs, on lyth e firm s p lu gg ed in to th e b ailo ut w in dows c ou ld a vo id th e massive lo sse s in flicte d o n e ve ryo nee lse . C omple xity p ro te cts th e p owerfu l, w hile e ve ryo ne e ls e is le ft in th e d us t.A g en era l princip al o f a ll bu sine sse s is tha t the y w ould like to be su bsid ize d b y th e p ub lic; an d ag en eral p rincip le of e con om ics is th at su ch sub sidies d isto rt th e m arke t p la ce. A ny risk of ag ov ernment b ailo ut, h id de n o r tra nsp are nt, is a s ub sid y, a nd th ese su bsid ie s h ave b ee n d ee ply.

3 Thomas Ph llippan , H as th e U .S . F in an ce In du str y B ec om e L es s E ffic ie nt? , Wo rk in g P ap er, N ov . 2 01 1.3


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im bed de d in o ur fin anc ia l s ystem, d iffe re nt pa rts o f w hich ha ve b een re pea te dly ba ile d o ut. A nyb eh avio rs th at g iv e ris e to lac k o f fu ll tra nsp are nc y impe de the workin g o f th e mark et p la ce , g iv erise to ren ts , a nd disto rt the ec onomy . .The combination of la ck o f tra nspa re nc y a nd ris k,a ss ociated w ith o ver th e c ou nte r d eriv ativ es, w as p re dic te d to b e letha l, a nd was.T here are costs of any set of regulations, but there are costs of not regulating. A s Lord A dairT urn er, Cha irman o f th e UK re gu la to ry a uth ority p oin te d out, th e lo sses from in adequa tere gu la tio n a re o rd ers o f magn itu de g re ate r th an th e lo sses a ssoc ia te d w ith requlatlons."We have se en n o argume nt from th e op po ne nts of th ese re gu la to ry ch an ge s tha t re fu te s th isa naly sis. A nd in de ed, th ese re gu latio ns h old the p romis e o f makin g fin an cia l m arke ts ac t morelike m arkets - and thus, not only of protecting the Treasury from another bailout, but ofe nhan cin g th e e ffic ie nc y o f o ur fin an cia l s ys tem and its a bility to se rv e th e res t o f the ec onomy .In short, the V olcker R ule's success should be m easured by how w ell it c an re du ce thecomp lexit y and opacity i n the banking system , as w ell as how w ell it can replace the falseliq uid ity o f b ooms and bus ts w ith re al liq uid ity th at fa cilita te s in ve stin g b y c lie nts a nd g rowth inth e re al e co nomy.The proposed rule does not yet achieve that goal. N or is this failure excusable as an exercise inre gu la to ry d is cre tio n. The s ta tu te a nd e ve ry p ie ce o f le gis la tiv e h is to ry c onne ct to it c le arlys how s th at th e la w Is s ys temic In o rie nta tio n a nd demands th at th e re gu la to rs re du ce th is s elf-s erv in g comp le xity a nd re pla ce i t w ith re al e co nomy-s erv in g s imp lic ity . S imply ta ke th es ta tu te .By defin ing p roprie ta ry t rading as any p ro prie ta ry p os itio n in th e tra din g boo k, a nd th enle tt ing back in only cert ain perm itt ed activ it ie s, sub je ct to lim its th at th e a otiv ity n ot g iv e ris e to acon flic t o f in te re st o r h ig h ris k, th e s ta tu te is d ire ctin g th e re gu la to ~s to pe rm it at b ank s o nly th emost b as ic c ap ita l ma rk ets s erv ic es th at are de sig ne d to s upp ort th e re al economy," Everythingelse should be excised from the core of the financial system . If the periphery w ants to engagein it, let them do so w ithout the core capital provided by FDIC in su re d depos its (a nd w ith ou t th eimplic itly in su re d mon ey-marke t mutu al fu nd s aving s, as well - h en ce th e V olc ke r R ule 'sco ve rag e o f sy stem ica lly s ig nific ant n on-b an k fin anc ia l comp an ie s). T his may n ot be thes implic ity tha t in du stry ap pea rs to be be gging fo r, b ut it is th e s impllc ity th at the law req uire s a ndth e p ro po se d rule d oes no t provide.Specifically, to im pleme nt th e stru cture n oted a bov e, a fin al ru le sh ould p ro vide clear. narrowsafe h arb ors fo r simple a ctiv itie s th at s erv e re al e co nomy cus tomers : u nderw ritin g fo r b as icstoc ks an d b ond s tha t ra is e c apital for rea l e co nomy firm s, genuine market-mak ing in p ta inva nilla c orp ora te a nd g ove rnme nt b on ds, an d h edg in g th at reduces exposure to vola tility ando th ers ris k th at may a rise in p ro vidin g th e marke t-mak in g a nd o th er s ervice s no te d a bov e.

4 S ee , Lo rd A da ir Turner, "Reform ing Finance: Are W e Being Radical Enough?U, 2011 Clare DistinguishedLecture in Econom ics and Public Policy, February 18, 2011; lord Adair Turner, "A fter the Crises:Assessing the Costs and Benefits of Financial Llberallsailon," Fourteenth C. D. D eshm ukh M em orialLecture,February 15, 2010.6 B ank H olding C om pany Act, Section 13(a),{d).

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Comple x s tru ctu re d p ro du cts a re Uhig h ris k a ssets " th at s ho uld b e e lim in ate d.6 Comp lex t rad ings tra te gie s a re "h ig h ris k tra din g s tra te gie s" th at s ho uld b e e lim in ate d. A nd , if a bsolu te s implic ityis truly w hat the in du stry d emand s, th en the re gu la tor sh ould prov ide tha t: the V olck er R ules ta tu te , in its a uth ority to s ub je ct p erm itte d a ctiv itie s to "any lim ita tio ns o r re stric tio ns that the[re gu la to rs ] may dete rm in e," g iv es re gu la to rs th e a uth ority to entirely e lim inate a ll securitie s andde riv ativ es trad ing by the b an kin g in dus try ." In du stry ca nn ot ha ve its c ak e a nd e at it too .Capitalism Requires Failure. and Failure Requires Transparency: The Volcker RuleDemands this Be ProvidedAccounting Transparency and Prompt Corrective Action, In re ce nt y ea rs , re gu la to rs h aveinc rea sin gly relie d on th e reg ula tio n of ca pital as th e ba sis for the ir reg ula tio n an d s up ervis ion o fthe la rge st fin an cia l ins titu tio ns . T his e ffo rt d ep en ds o n a mean ing fu l measu reme nt o f a firm'scapital, w hich in turn is only as good as a firm 's understanding and valuation of the assets it isholding. W e have seen over tim e that even the firm s w ith the sm artest risk m anagers and high-powered com puter m odels have gotten valuations of assets - and capital - very w rong. Itha pp en ed in LTCM. I t happened in th e valu atio n o f s ub prime deriv ativ e securitie s d urin g th erecent f inanc ia l c ris is . It is likely to happen again, C apital charges are one tool, but they areo nly o ne p iec e of the pu zz le. T he y must b e compleme nted b y ac tiv ity restric tio ns th at sim plifyb an k a ctiv itie s a nd suppo rt h on es t v alu atio ns o f a ssets a nd cap ita l.I~ rec en t y ea rs, b an kin g re gu lation s ha ve p erm itted , ev en en co ura ge d, ba nk s to use comp lexm odeling devices to evaluate the capital they hold against positions. N ot only has this ingeneral perm itted banks to low er the am ount of equity they hold to w ithstand losses, but it a lsoh as p erm itted , e ve n en co ura ge d, b an ks to s tru ctu re eve r more hig hly comp lex d eriva tiv es an dsecuritie s, s ometimes fo r c lie nts b ut more fre qu en tly w ith a n e ye towa rd s g iv in g th emse lv eswha te ve r ris k e xp osure th ey wan te d fo r th eir own p ro prie ta ry p os itio ns .The se bespo ke a ssets a re h ig hly d etrimenta l to b an k ba lan ce she ets b ec au se th ey are va lue dth rou gh comp lex c ompu te r mode ling , an d o cc asion ally by a trade w ith or estim ate by a friendlytrader at a com petitor firm engaged in the sam e type of asset myth-rnaklnq, Mark to m odel isno t a s ou nd v alua tion metho d. Mode ls a ssume infinite liq uid ity th at d oe s n ot ex ist. T his o pa citycreates a m ark-to-m yth nature for bank balance sheets, w hich m eans bank capital - thatrem ainder after liabilities are reduced from assets - is also a w ork of fiction. M oreover, as"tra ding b oo k" a ss ets , th ey h av e ten de d to b en efit from s ign ific an tly low er ca pital ch arge s th ancompa rab ly illiq uid as se ts in the "ba nk in g bo ok ." M ark-to ~myth b eg s th e q ue stion whe the rholding such an asset can be said to be tradinp at all, m uch less w hether the asset can bevalu ed lik e a liq uid as se t in a way th at is mean ing fu l.T his te nd en cy towa rd s mark -to -myth valu atio ns is fu rth er e xa ce rb ate d b y compensatio ns tru ctu re s tha t rew ard the ba nk ers ba se d on h igh er ac co un tan cy v alu ation s. T hes e s tru ctu re sa ctu ally do ub le d own on risk b ec au se in add itio n to o ve rs ta tin g cap ita l, th ey a ls o e ncou ra ge6 Ba 'nk Ho lding Company Act , Sec tion 13(d) (2 ) (A) (i i) .7 Bank Ho ld ing CompanyAct , Section 13(d)(1) ( in t roductory paragraph).

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tra de rs to "s hift th e d is trib utio n," p ushin g mo re ris k In to a fa t ta il whic h is p ra ctic ally b ac ke d onlyby a conjectural call option on the American taxpayers. T hat call w as exercised in 2008. Itsris k-a dju ste d p ric e made it a ve ry p ro fita ble h ed ge, for in du stry - an d ve ry u np ro fita ble fo rtaxpayers.This is a d rive r o f s ys tem ic ris k b eca us e w ith ou t c la rity w ith re ga rd s to c apita l, it is im po ssib le tod ete rm ine whe n a firm is n ear failu re . T his mea ns "p romp t c orre ctive a ctio n" ca nn ot b ee ffe cte d, a nd re so lutio n simply be come s a n e xe rc is e in the a pplic atio n o f p olitic al p ower - ad ange ro us pos itio n in a world post-Citizens United, o r a ny world , fo r th at matte r.W hile 8asellll ru les look to im prove elem ents of bank capital, they do not go far enough ind ea lin g w ith th is hig hly p ro fita ble b ut high ly d an ge ro us driv er o f sy stemic ris k. O nly th e V olc kerRule , a nd pote ntia lly th e u pcom in g Basel revlew of the trading book, dem ands this problem bead dre ss ed . Wh at is re quire d is s epa ratio n o f th e sa fety n et from th e p ro prie ta ry tra din g o ffin ancia l in st itu tio ns . U .S . t axpaye rs should not be subsid iz ing, trade rs ' bonuses .Specifically, the marke t-mak in g p erm itte d a ctivity mus t be lim ited o nly to a sse ts th at ca n b ere lia bly v alu ed in , at a m in imum , a mod era te ly liqu id mark et e vid enc ed b y tra din g w ith in areasonable period (for exam ple, w ithin a w eek). This w ould m ean that a bank m ust m ark ana sse f th rou gh a re al tra ns actio n (an d no t s im ply w ith in te rd ea le r tra de s) o n a re gu la r b asis. Fora ssets th at c an no t b e so re lia bly v alu ed , in p artic ula r b espo ke deriv ativ es , s tru ctu re d p ro du cts ,and other assets that, as the proposed rule puts it in fo otn ote 149 , "tra de only b y a ppoin tment,"if at all, they should not be perm itted under m arket-m akinq." A s such, to the extent that ab an kin g o rg an iz atio n is p erm itte d to w rite th em , whic h is h ig hly q ue stio na ble from a superv is orya nd macro pru de ntia l p ers pec tive , th ey s ho uld b e tre ate d a s an illiqu id be sp ok e loa n, w ith th e fu llcap it al cha rges tha t would arise under the banking book for such a risky asset.S ome may a rg ue tha t th is ty pe o f lim ita tion w ill re du ce liq uid ity to th e small a nd m id -s iz edcorp ora te b ond ma rket. P ro pe rly c on stru cte d, ru le s g overn in g ma rket-ma kin g should n otmateria lly im pa ct th e a bility o f th ese iss ue rs to raise c ap ita l. T he y are lik ely , h owev er, a ndshould , s ig nific an tly , impac t th e "ma rk ets " whic h a re d om in ate d b y bespo ke deriv ativ es a ndc omple x s tru ctu re d p rod uc ts , w hic h a dd little to the rea l e co nomy , a nd a re fre qu en tly s im plyd isgu ised le ve raged p roprie ta ry bet s.T he VO lc ke r Rule Is Structured to Be A Firewall to Stop Risk PropagatIon Across theSystemCrowded Trades and Systemic Resilience. T he second m ajor issue that the V olcker R uleaddresses is the risk of our largest banking organizations driving - and getting caught in - theb ooms a nd b usts th at h av e b ecome s o p re va le nt in fin an cial m ark ets re ce ntly.

8Fed era l R eg is te r, V ol. 7 6, N o. 2 15 , N ov embe r 7 ,2 01 1, p . 6 88 71 .6


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Again ,' th e pro blem a rise s from tra din g b ase d o n mark et a pp re cia tion , a nd th e e ns uing s ea rchfo r "alph a" re tu rn s. B eca us e tra ders g et p aid w he n va lua tio ns g o u p, th ey a re in ce ntiv iz ed top ut th eir tra de s in to th e m id dle o f c rowde d marke ts, a nd ev en to d rive mark ets in th e d ire ctio nsof their trade. T he problem is that these crow ded trades propagate and exacerbate anyp ro blems in tho se mark ets . B eca us e c orre latio ns in crea se in a c risis, p rob lems a re fu rth ermagn ifie d a nd tra nsm itte d a cro ss a sset c la sses . A s pos itio ns a re impaire d a t firms , fire sa le sand runs result - up and until bailouts are deployed to stop them , as the Federal R eservere co gn iz ed in 1998 w ith the c olla ps e a nd b ailo ut o f L TCM .9In s hort, o ur la rg est ba nk s sh ou ld b e se pa ra te d from th es e mark ets , a nd th e ris k p ro pa ga tio nthey cause , by astrong firewall. A s tro ng firewa ll w ill s ig nific an tly a dd to th e re silie nc y o f th efin an cia l sy stem a s a who le .Specifically, to e ffe ct th is firew all, firm s n eed to b e o nly e ng ag ed in true marke t-mak in g o r ris k-m itig atin g h edgin g tra de s, a nd not d is gu is ed p ro prie ta ry tra din g. Certa in ly , th e d iffe re ncebetw een them is one of degree, not kind, but as the degree differences becom e large, theybecome s ta rkly differe nc es in k in d. A cc ord in gly , the way to e ffe ct th e fire wa ll is to e re ct an arrow, c le arly d elin ea te d perm itte d spa ce , o n a lowe st-le ve l, d es k-b y-d es k b as is , w ith in whic hcan o ccur s afe , re al-e co nomy serv in g ma rket-ma kin g in b as ic p ro du cts a nd ris k-re du cin g (fo rboth system and firm ) hedging. B eyond that sim ple space should be a ssumed to be suspectpropr ie tary t rad ing.

, T he p erm itte d s pa ce fo r marke t-mak in g s hou ld be e sta blis he d th ro ug h b rig ht lin e ru le sestablishing a wee kly b ala nce s hee t w ith in w hic h mark et-mak in g a nd h ed gin g (on a d esk -b y-desk basis) can occur. A s long as the trader, over the tim e period, has stayed w ithin thebalance sheet, he or she should be presum ed - absent other evidence, such as high volatility orlow re ve nue-to -ris k me tric s (a ga in , b rig ht lin es a re n eeded, b ut re gu la to rs s hould h avediscretion to go beyond them ), that the trader is market-maklna." This ba la nc e s he et amo un ts hould b e small, a s ma rk et-ma kin g should n ot re qu ire s ig nific an t amounts o f in ve nto ry .Inventory levels m ust be rational based on tw o types of m easurem ent: the risk m ust bep ro portion ate to th e mark et-mak in g b usin es s th at it s up ports ; an d th e amou nt s ho uld b econ sis te nt w ith tu rn over in th e u nderly in g ma rk et-ma kin g bus in es s.T his p re sump tio n p erm its a trad er to h old a p ositlo n o ve rnigh t o r,' f or ce rta in o f th e le ss liq uidcorporate bonds, even over several nights. H ow ever, firm s should enforce an average over atim e period, w hich m eans that on other days the trader w ill need to close the book out flat - as

9 Indeed, th e pu rposed re ason the N ew Y ork Fed eral R eserve Ba nk led the bailou t of LTCM w as notbecause of any desire to save LTeM b ut b eca use a ll th e o th er m ajo r W all S tre et b an ks h ad c ro wd edtra des in the same direction as LTCM, and a ny collap se by LTCM w ould d ecim ate the asset m arkets andth us th e c ap ita l p os itio ns o f th e firm s.to Marke t-m akin g is a re lia bly p ro fita ble b usin es s, a nd ca n re tu rn a S ha rp e R atio o f 3 , b ut w on 't re tu rnthe outs iz ed p rO fits o f that p ro prie ta ry tra din g c an d eliv er, w hic h h av e low S ha rp e R atio ns o f 1 o r le ss ,(h ig h ris k-to -re ve nu e) a nd re ly o n tra de rs s hiftin g th e d is trib utio n c urv e. S ha rp e R atio s a re le ss re lia ble inle ss liq uid ma rk ets (a no th er in dic atio n th at s uc h b us in es s may n ot b e tra din g a ctiv itie s a t a li).

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many a re a lrea dy re qu ired to do at w ell m an age d firm s. T he go al of this structu re is to e lim in ateth e capac ity fo r th e tra de r to e ffe ct la rg e carry -tra de pos itio ns .S pecial atten tion sho uld b e pa id to op tio ns tra ding a nd othe r de rivatives . E ven if tra de d on a ne xc ha ng e in a liq uid ma rk et, th es e a ss ets a re h ig hly v ola tile a nd d iffic ult if n ot im po ss ib le toe ffe ctiv ely h ed ge e xc ep t th ro ug h a c omp le te ly ma tc he d p os itio n. In th es e c as es , o ptio ns a nds im ila r d eriv ativ es may n ee d to b e re qu ire d to b e s old o nly a s ris kle ss p rin cip al tra de s "o n b eh alfo f cus tome rs ," o r s ignif icant ly lim it ed thr ough capit al charges.It is e ss en tia l th at th is p erm itte d s pa ce b e g au ge d a t th e lo we st-le ve l tra din g d es k b ec au sehed ging ca n o nly b e re liably m ea sure d on a n as set cla ss ba sis . A s the sta tute re quires, h ed gess ho uld b e "s pe cific " to ris ks a nd "s pe cific " to p os itio ns , a nd n ot o n a p ortfo lio b as is . T his isb ec au se h ed gin g b y s pe cific p os itio ns lim its c ro ss -ma rk et c orre la tio n, w hic h c an b re ak d own intime s o f s tre ss .Monito rin g th ese a ctiv itie s is e ssen tia l, a nd re gu la to rs a nd superv is ors to da y have an eno rmousn ee d fo r re al-tim e, re lia ble d ata . T o e sta blis h th e b rig ht lin es n ee de d to s et fo rth th e p erm itte dspace fo r genu ine rna rket -mak lnq and r is k~m i tig a ting hedg ing , r egu la to rs shou ld in ves tiga tedata from a ra nge of firm s, includ ing ov er tim e periods p rior to the fin anc ia l crisis , as w ell as atp re se nt. M ore ov er, re gu la to rs c an g iv e c on fid en ce to mark et p artic ip an ts th at th ey h av e n otb ee n c ap tu re d b y in du stry b y ma kin g th e o n~ go in g d ata from th e firm s (th e me tric s) a va ila ble toin ve sto rs th ro ugh pub lic d is clo su re , p erh ap s on a dela ye d bas is .C ritic ally , th is p erm itte d spa ce should b e p ro vid ed fo r p la in v an illa p ro du cts th at ra is e cap ita l o rp ro vid e in te rme dia tio n s erv ic es th at b en efit th e re al e co nomy, a nd n ot fo r c omp le x a ss ets o rc omp le x tra din g s tra te gie s th at s imp ly e xtra ct re so urc es from it. This may re qu ire re gu la to rsdefin ing the type of sim ple stocks and bonds that firm s can hold . T his is not beyond thetra ditio n o f U .S :.b an kin g re gu la tio n, a s fo r ma ny y ea rs , b an ks were lim ite d o nly to th e mos tb as ic d eb t a ssets , a nd b ro ke r-d ea le rs we re p ra ctic ally lim ite d to o nly fa irly liq uid s ecuritie s, d eb tan d e qu ity. T he regu la to ry tren ds loo sen in g tho se ru les , inc lu din g th e exp an slo n o f the use ofderivatives and the "hed ge s" tha t c an g o to bac k them, m ust b e reve rsed . A final rule s hou ldin clu de cha ra cte ris tic s fo r s imp le , p la in v an illa a ssets th at b an ks can tra de .N or s ho uld tra din g a ctiv itie s b e u nlim ite d. T he ra ng e o f re la tiv e v alu e a nd c omp le x a rb itra ges tra te gie s th at h av e a ris en in re ce nt y ea rs d o n ot b elo ng in o ur la rg es t, m os t c ritic al fin an cia lfirm s. Expanding the volum e of trading should not be seen, in and of itse lf. as provid ing asuffic ien t en oug h s ervic e. T he lesso ns of th e F las h C ra sh sho uld n ot be a s quickly forgo tte n asthe le sso ns of LTCM were . A final ru le sho uld en sure th at th ese trading stra tegies n ot b econducted.F in ally , c omp en sa tio n is a p owerfu l to ol th at mu st b e fu lly u tiliz ed to s up po rt th e fire wa ll b etw ee nc omple x, h ig h ris k a ctiv itie s a nd s imple , lo we r ris k ma rk et-mak ln s. R atio na l a cto rs g o in tofin an ce b ec au se o f th e p owerfu l in ce ntiv es it p ro vid es . R eg ula to rs mu st e ns ure th at in ce ntiv esa re fu lly a lig ne d in fa vo r o f th e lim ite d ma rk et-mak in g a nd rls k-m itiq atin q h ed gin g s pa ce s et fo rth

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a bo ve , a nd n ot d es ig ne d to in ce nt h ig he r-ris k p ro prie ta ry tra din g. In de ed , w e e nc ou ra ge y ou tolo ok s pe cific ally a t th e h ed ge fu nd in du stry . B ec au se h ed ge fu nd s ta ke la rg e ris ks , b ut a re sma llenough and do fail, their m anag ers m ust put in place procedures to lim it risks.T wo suggestions m ay be valuable here. F irst, traders should be paid based on the results of thepositions they put on and should only be paid once all positions are unw ound. T his willdiscourage them from carrying inventory and encourage them to get out of positions. It w ill a lsolim it th e p ra ctic e o f c olle ctin g b on us es b ase d o n th e p ric e a pp re cia tio n o f a ss ets in th e s ho rt-te rm , w he n th e lo ng -te rm p erfo rman ce o f th e a ss et is h ig hly q ue stio na ble . S ec on d,compensa tion should be r is k-adju sted andlor b as ed o n p erfo rman ce re la tiv e to a n o uts id eobject indicator - for exam ple , an index. M arket-m akers should not outperform the index -th ere is n o "a lp ha " in mark et-mak in g - a nd mark et-makin g s ho uld n ot b e h ig hly v ola tile .In ce ntiv es should rewa rd ris k-m in im iz atio n a nd fid elity to th e g oa l o f ma rk et-ma kin g and rlek-reducing hedg ing .Regulators Should Use Apply the Volcker Rule Globally Until Foreign Regulators Agreeto a Coordinated Cross-Border Resolution RegimeInternational Coordina~fon. Much media attention has com e to the purporte d concern byfo re ig n m in is trie s o f fin an ce and fo re ig n b an kin g re gu la to rs re ga rd in g th e pote ntia le xtra te rrlto rla l a pp lic atio n o f th e Volc ke r Ru le . F irs t. it should b e note d th at th e p rin cip al fo re ig nalternative to the U .S . for banking and securities, nam ely the U nited K ingdom , is on track toim plem ent a variation of the V olcker R ule in w hat is know n as the V ickers C omm ission's ring-fe nc in g p ro po sa l. Mo re importa ntly , h owever, th e q ue stio n of ex trater ritor ia l appl ica ti on shou ldbe addressed head on:

Specifically, th e V olc ke r R ule s ho uld b e a pp lie d g lo ba lly to all f irms until a coordina ted cross-borde r re so lu tion r eg ime is fully e stab lished.T he V olc ke r R ule Is o ne o f th e o nly a va ila ble to ols fo r lim itin g th e ris k o f fin an cia l c ris es .A ssum ing it is im plem ented correctly - as outlined above - th e V olcker R ule has the potentia l toin cre ase tra nspa re nt a ccountin g n eeded fo r mean in gfu l p rompt c orre ctiv e a ctio n, while lim itin gth e risk s o f c on ta gio n from c rowd ed tra de s a nd fire sa le s. U ntil a cre dib le c ro ss -b ord erre so lu tio n re gime is estaollshed," a ll g lo ba l fin an cia l in stitu tio ns a re e xposed to th ese ris ks , a ndthe preventative tools of the V olcker R ule should be applied to them . O nce such a resolutionre gime is e sta blis he d in te rn atio na lly , th en may it b e more a pp ro pria te to le t e ac h c ou ntrye sta blis h th e p ro te ctio ns (s uc h a s s ig nific an tly h ig he r c ap ita l c ha rg es ) - o r p ro vid e fo rperm anent bailouts - that it so chooses.S ho uld p ro gre ss o n s uc h a re so lu tio n re gime b e fo rth comin g, re gu la to rs may c on sid er re sto rin gtra ditio na l te rrito ria l a pp lic atio n o f th e ru le , o n a c ou ntry b y c ou ntry b as is , M ore ov er, e ve n o nc e11 For m ore on designing a s uc ce ss fu l c ro ss -b ord er re so lu tio n re gime , s ee Robert J ohns on , CredibleR eso lu tio n : W ha t It Takes To End Too Big To Fail, in Robe rt Johnson, Er ica Payne, eds, MAKE MARKETSBE MARKETS, ROOSEVELT INSTITUTE (2010).

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a global resolution agreement is put in place, application of the "limitations on permittedactivities" should still be utilized to require maintenance of global minimum standardsestablished by the Basel Committee.Conclusion: Remember the GoalIn conclusion, we urge the regulators to remember their mandate. They must implement the lawin a manner that achieves the purposes of the law. In the case of the Dodd-Frank Act's rules onproprietary trading and relationships with hedge funds, that purpose is clear: to timit the risk ofpreviously uncontrolled trading activities that brought such destruction and mayhem to theeconomy, to restore banking organizations to the function of supporting the real economy, andto limit the abuses of bailouts that offends the American people and undermines faith ingovernance and the capitalist enterprise that has made this country great.

rLe~!itzU i~;;~i;l~rOfessorolumbia University

Sincerely,

Executive DirectorSenior Fellow and DirElctor of Global FinanceRoosevelt Institute

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Johnson-Stiglitz letter