Size Matters: Dodd Frank Doesn't Adequately Limit Systemic Banking Risk

Last week's announcement that Goldman Sachs had invested somewhere around $450 million in Facebook, giving the social networking giant a notional value of $50 billion, reveals the shortcomings of the Dodd-Frank financial reform law passed last year.

The “Volcker Rule,” proposed by former Fed Chairman Paul Volcker and incorporated in the new law, aims to limit banks' ability to engage in proprietary trading – using their own funds to trade securities, potentially in conflict with the interests of the clients whose assets they manage. The Volcker Rule itself was something of a compromise measure. Ideally, the largest banks – those like Goldman Sachs, Citigroup, and J.P. Morgan Chase, which are deemed “too big to fail” would have been broken up and prevented from ever again becoming so big that the collapse of even one of them could threaten to bring down the entire global banking system. But that ideal was strangled at birth by legislators on both sides of the aisle, whose relationships with the banking sector can generally be described as “cozy.”

The Volcker Rule prohibits banks from short-term securities trading for their own accounts and also restricts their ability to invest their own funds in hedge funds and private equity. The Volcker Rule, however, did not and would not prevent investments of the kind Goldman Sachs just made in Facebook, since it does not apply to banks' direct purchases of securities and other assets – referred to as “principal investments” – which are considered longer-term, and hence, less risky activities.

Why should this matter? After all, Facebook is a big and successful company whose shares, though they are now privately traded, are almost certain within the next year to become publicly traded in an initial public offering likely to be managed by Goldman Sachs. This could, at the very least, be considered a conflict of interest since Goldman Sachs, in addition to reaping hundreds of millions of dollars in advisory fees, would also be among the main beneficiaries of the probable initial run-up in the price of Facebook shares.

In spite of impassioned protests to the contrary, the so-called “Chinese Walls,” which are supposed to separate different and potentially conflicting parts of banks' operations, have repeatedly been revealed to be just as porous as the Great Wall of China itself, which in the 13^th century failed to keep the Mongol hordes from overrunning the Chinese heartland.

The likely conflict of interest in the various Facebook transactions in which Goldman Sachs will participate is the least of our worries, however. For a bank like Goldman Sachs, $450 million is just walking around money. It could lose its entire investment in Facebook with minimal impact on its bottom line or on the stability of the banking system. But the fact that Goldman and other banks could invest 10 times – or 100 times – this amount in risky assets is very worrisome.

The Financial Times reported last November on the strategies of several big banks, most notably Goldman Sachs, JP Morgan, and Morgan Stanley, to avoid the most onerous restrictions of the Dodd-Frank law by making longer-term proprietary investments. At the end of last September, Goldman Sachs had $22.9 billion in principal investments on its books and JP Morgan $6.8 billion, some of these through funds and others directly. This is big money. When Long Term Capital Management, a hedge fund, collapsed in 1998 having lost $4.6 billion, the Federal Reserve Bank of New York organized a bailout by LTCM creditors to stave off a chain reaction that could have brought down the global financial system. LTCM, of course, did a lot of  short-term trading. In the popular imagination, short-term investing is speculative and risky, and long-term investing prudent and responsible. Nothing could be further from the truth. The Financial Times article pointed to Lehman Brothers' participation in the $23.6bn leveraged takeover of Archstone, a property group, in mid-2007 as a significant contributing factor to its collapse a year later. Property investments, millions of American homeowners and real estate investors now know, can be as speculative and risky as shorting penny stocks. Investments in hot Internet stocks can be equally risky, as anyone who invested in the NASDAQ Index in 1999 could tell you (the NASDAQ peaked at 5,000 in March 2000, and yesterday closed at 2734).

Yesterday's New York Times reports that “Goldman Sachs, after a nine-month review of its business practices, has concluded its operations need only a fine-tuning, not a complete overhaul.” They would say that, wouldn't they? The review also restated Goldman's top principle: “Our clients' interests have always come first.” It must be hard for Goldman executives to say that with a straight face, now that the bank has become notorious for betting against its clients.

Solutions to the problem may be obvious, but the likelihood of their adoption is slim, and their effectiveness may also be limited. The Volcker rule could be extended to all proprietary trading by banks. This might affect JP Morgan and Citi, among others, but Goldman Sachs and Morgan Stanley, which obtained commercial banking licenses only in 2008 to qualify for federal bailout money, could easily jettison those licenses and go back to business as usual. More radical solutions suggest themselves: reintroduction of a modified form of Glass Steagall, the 1933 law that forced a split between investment banks and commercial banks, or even breaking up the big banks and preventing them from ever again becoming too big to fail. Proprietary trading by any publicly traded bank could and probably should be banned as well, especially now that Wal-Mart is making noises about getting a banking license. Until the 1980s all Wall Street firms were partnerships, in which the partners put their own capital at risk. This naturally limited the risk these institutions were willing to assume and also limited their size. Once these firms went public and started playing with other people's money, they grew exponentially and took on insane levels of risk. These solutions were almost certainly considered in House and Senate debates over Dodd Frank and dropped because they lacked the votes to pass.

We are now left with the worst of both worlds. New regulations, written with the active input of the big banks and their alumni, which lull us into thinking we are now safe from a repeat of the 2008 collapse, but which serve mainly to further entrench the big banks' dominance without reducing systemic risk one iota. If the financial crisis has taught us anything, it's that it's Goldman Sachs's world; we just live in it.