Proprietary Trading by Citicorp:

Andrew Hall, superstar energy trader, has made Citicorp hefty amounts of money through the proprietary trading his group (Phibro) undertakes in the energy markets. More power to him. The terms of his contract, so far as one can tell from news reports, obligate Citicorp to pay him something on the order of $100 million, essentially as a percentage of the profits from his trades.

The question, as a WSJ editorial observes today, is not whether Citicorp - despite massive government bailout money not related to Hall's unit - has an obligation to honor the contract (although Citicorp, responding to political pressures, seems to be balking). The question is whether Citicorp, as a bank holding company with commercial banking deposits guaranteed by the Federal government, ought to be permitted to engage in proprietary trading of the kind that Hall undertakes, whether profitably or unprofitably or, in other words, ought the bank holding company to be undertaking such risks at all. If Citicorp is deemed too big to fail, and with its government guaranteed units contributing some part of the capital of the larger corporate entity, should it be allowed to engage in proprietary trading of this kind in the first place.

Should Hall be spun off to take his operations elsewhere - somewhere, so hopes the Journal editorial, where the possible failure of his energy market bets would not involve taxpayer bailouts. Or, in some ways worse, the Fannie-Freddie situation of a cost of capital as a base from which to place those bets that is not artificially ( and eventually, I would add, drawing on the experience of Fannie-Freddie, politically) lowered by the presence of the government guarantee?

[A]n important issue—especially for taxpayers—is whether Citigroup ought to own a high-risk trading operation like Phibro. As a bank holding company, Citi is funded in part with deposits insured by the taxpayer. And we know from painful experience that regulators think Citigroup is too big to fail. Citigroup executives and board love the revenue and profit that Mr. Hall generates, and they've left him on a long leash because his risky bets on the direction of oil prices have generally paid off. But if those bets go wrong and they jeopardize Citigroup, then taxpayers get hit with the bill.

In Phibro and Citi, we can see writ small the debate over financial regulation that took place inside the Obama Administration. Former Fed Chairman Paul Volcker has been warning for months that such proprietary trading is incompatible—and intolerable—with a taxpayer guarantee against failure. But he was opposed by the Obama Treasury, White House powerhouse Larry Summers, not to mention the ghost of former Treasury Secretary and Citigroup exec Robert Rubin and most of Wall Street.

Mr. Volcker's advice would have meant restraining bank risk-taking in ways that would also limit bank profits. But this is politically hard to do in the face of Wall Street opposition. It's so much easier to preach about the wonders of a new "systemic regulator" and roar against $100 million bankers. But for all of their banker-baiting, Democrats in Washington still want to let the biggest banks place enormous bets with taxpayer guarantees. High-risk, high-reward businesses play a vital role in the American economy, but Fannie Mae should have taught us that disaster for taxpayers is inevitable when private reward is combined with socialized risk.

The editorial notes that Paul Volker has been calling such proprietary trading by entities that also have related commercial, guaranteed banking units a bad idea and something that should be prohibited by legislation and regulation. The bank corporations do not want to do this, for obvious reasons that it erodes the profits, lowered cost of capital, and public insurance against losses. It does not appear that a prohibition will make it into the various pieces of financial reform legislation proposed by the administration.

The most interesting part of this, however, is the Journal's observation - a view I basically share - that the administration's alternative form of regulation is instead to simply treat this as a problem of monitoring and avoiding future situations of systemic risk. Volker's view amounts to prohibiting an activity that is at the heart of creating institutions that are not just too big to fail, but which also have an incentive to make bets inappropriate, one might have thought, to the risk that the public fisc should be willing to bear (viz., the liquidity risk of a run on the bank, rather than the solvency risk of leveraged bets induced by distortions of moral hazard).

The administration's proposals in effect kick the can of the substantive question down the road, and invest the solution in a vague process that depends not upon structurally proper incentives for the banks and financial institutions, but instead on the ability of the Fed to identify, police, and prevent eruptions of systemic risk as they develop. I understand, and sympathize with, the difficulties of fending off Wall Street banks and the lobbyists. But this seems to me a structural incentives problem that is way, way beyond problems of compensation czars and such populist sounding measures that do not really get to the heart of the matter here.

I'd be interested in hearing serious arguments against Volker's suggestion to ban proprietary trading by such institutions as Citicorp. I realize that there are tradeoffs - there are ways, for example, in which the pursuit of trading profits by financial institutions mirrors the problems - but also the 'solutions' - of S&Ls years ago. I'd be interested to hear of reasons why either proprietary trading is not the problem of structural incentives I've here suggested, following the WSJ editorial, or why banning it is worse than the administration's alternative. The administration's alternative seems to me not to address fundamental structural incentives, while making the Fed, for yet another gargantuan issue, the first and last, remarkably ad hoc, trip wire of protection against systemic risk.