Which One of These Things is Too Big To Fail?

If you had money invested during the financial crisis that began in 2007, you may still be recovering from the bungee jump you may have experienced in the global financial markets largely brought about by the unwinding of complex securities held by a handful of large banks.

The crisis also shined a spotlight on the fact that several banks were operating in gray areas — for example, selling clients investments via one department that the bank itself was betting against in another department. Or that banks had the ability to profit from trades placed with deposits from their clients.

To enable better oversight and ideally prevent these types of events from happening again, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (“The Act”) into law in July 2010.

It’s a wide-sweeping law seeking to prevent “too big to fail” scenarios as well as to protect consumers from predatory practices. It’s so sweeping that one has to ask if there’s any way this Act could fail?

So far, The Act is actually causing an impact with provisions that aim to put a roach motel in every corner of the room. Let’s look at proprietary trading as an example.

Proprietary trading desks at banks previously could have made highly speculative bets with client deposits, and it didn’t matter if the bets were in line with or against positions that the banks knew their clients held.

The Act — with help from the Volcker Rule — tamped down on these activities. As a result, we began to see proprietary trading desks shutter and traders teaming together to form independent hedge funds which in the past have had less oversight than other Wall Street entities.

But in a brilliant move, The Act also requires that hedge funds now explicitly document, retain and report to the SEC what bets they’re making. Hedge funds must now make quarterly to annual regulatory filings that outline the geographic exposures, counterparties and extent of leverage in their positions. The only thing left in my opinion is standardizing how each item is reported so that the SEC is comparing apples to apples.

The jury is still out on whether The Act will ultimately create transparency for the good of investors and consumers, or if The Act will cause more obscure techniques to be created for banks to make profits. The former may actually cause Wall Street to shrink for the good if bankers leave being unable to create alpha like in days past, but the latter could cause another bubble in 3-5 years.

Or perhaps we’ll see another HBO movie in a few years also called “Too Big to Fail” but this time starring Senators Dodd and Frank, and Volcker.  I’ll be watching this story unfold.