Somewhere in the debate about prohibiting proprietary trading in certain banks we will need a decent understanding of what proprietary trading is. So I thought I would illustrate the difficulties.
Imagine a suburban bank which takes deposits and makes mortgages.
The deposits are primarily at-call and pay a floating interest rate. Legally they bank has overnight money – and if interest rates rose then the next day the customers could (in theory) all withdraw their money and/or ask for a higher interest rate. The bank does not really know what interest rates it will be paying next week let alone in three years.
In reality the customers of the bank are sticky. There is no way that everyone will pull their money in response to a short term rate rise. The funding of the bank is of uncertain duration.
On the asset side the bank lends on fixed rate but refinanceable mortgages. The bank really has no idea how long the mortgages will last. If rates go down they might all be refinanced tomorrow. People might just sell all their houses and repay their mortgages. In reality however the customer are likely to be somewhat sticky. On the asset side the bank has uncertain duration.
This plain vanilla bank has interest rate risk. If rates rise their funding costs will rise relative to their asset yield. If rates fall their assets will refinance. Their funding cost might also fall – but at the moment the funding cost seems pinned by the zero-bound.
Some hedging of interest rate risk here seems entirely sensible. Banks (and more often S&Ls) have failed in the past because they failed to hedge this sort of interest rate risk. However as both the assets and liabilities are of uncertain duration there is no way of knowing just how much hedging is required. There is a choice here – it is a proprietary choice (in that the bank will trade off hedging costs against profits). And there is no easy way to legislate that choice away.
I have even seen a bank swap its fixed rate subordinate funding (fixed rate preferred shares) into floating rate and call it a hedge. That looked like proprietary trading to me as it earned a profit (the yield curve was steep) and the bank was playing the yield curve very heavily in advance of that hedge. The so called hedge increased the risks the banks faced if short rates rose. The auditor signed it off as a hedge.
If the auditor, the bank and I disagree as to what is a hedge in the simplest of examples then I have no idea how we are going to find a legislative solution in complex examples.
Real prop trading is like pornography. I know it when I see it.