Citizen Action Monitor

Economics prof warns U.S. is precipitating another global financial crisis

No 174 Posted by fw, May 14, 2011

Paul Jay, Real News Network Editor: So, in other words, as Standard and Poor’s said: If you don’t take a position on this – and I’m talking to us, the viewers – we could be risking another $5 trillion of public money again?

Gerald Epstein, Professor of Economics: Absolutely. It’s even worse than that. Because what’s happening right now – Ben Bernanke at the Federal Reserve, they’re trying to restore the health of these banks by keeping short-term interest rates really low, allowing the banks to take that money and engage in proprietary trading and make a lot of money. And the Fed is hoping that that’s going to restore the balance sheets and the health of the banks, and so that we won’t have a financial crisis. But, in fact, what they’re doing is facilitating precisely the kinds of behaviour that led to the first financial crisis [2008-]. Source: Gerald Epstein: Real message of S&P downgrade of US debt outlook is threat of another meltdown of finance sector.  The Real News Network, May 8, 2011. (NOTE: This video is embedded at the end of this post).

In my preceding post, “People aren’t stupid, but when it comes to politics they are ignorant, lazy and easily satisfied with pat answers to difficult questions, the piece reported on a study by a pair of political scientists, which confirmed what many suspect: “most people pay very little attention to politics [and] don’t understand the world they’re living in.” Moreover, they observed that “one of the reasons for the drift towards deregulation is that politics has been too slow to resist it.” (Winner-Take-All Politics: How Washington Made the Rich Richer – and Turned Its Back on the Middle Class by Jacob Hacker and Paul Pierson, Simon and Schuster, 2010).

Without a doubt, these shortcomings of modern democracy contributed to the 2008 financial crisis, often called the Credit Crunch, and the Global Financial Crisis. This collapse of markets around the world is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. Originating in the United States, the global repercussions were devastating and recovery continues to sputter.

Buckle up folks because if the analysis in a 2010 paper by Economics Professor Gerald Epstein is sound, Federal Reserve Chairman Ben Bernanke may be “facilitating precisely the kinds of behaviour that led to the first financial crisis.”

Readers who have made it this far in this post are presumably not members of Hacker’s and Pierson’s “ignorant, lazy and easily satisfied” crowd. Good thing, too, because this is a longish post more likely to appeal to those who are not so “easily satisfied” with “pat answers to difficult questions.”

I urge you to invest the time and cognitive energy to read this post. Although the paper deals specifically with the situation in the U.S., it has significant implications for Canada. After all, Canada did not escape unscathed from the 2008 collapse of financial markets.

What follows is a slightly edited version of a research paper by Gerald Epstein and associates: Proprietary Trading Is a Bigger Deal Than Many Bankers and Pundits Claim, Political Economy Research Institute (PERI), University of Massachusetts, Amherst, February 18, 2010. Sub-headings, font highlighting and hyperlinks have been added to facilitate browsing.

Proprietary Trading Is a Bigger Deal Than Many Bankers and Pundits Claim by Gerald Epstein

Bankers, business press and Republicans say proprietary trading did not contribute to the 2008 collapse

President Obama’s endorsement of the “Volcker Rule” – a set of proposals designed to reduce public financial support for risky proprietary trading and hedge/private equity fund ownership by commercial banks and bank holding companies – has elicited an intense chorus of responses from bankers, economists and policy makers. The most vehement and uniform have come from the bankers themselves, and have been echoed uncritically by much of the business press and many Republican politicians. These responses have been twofold. First, proprietary trading had little to do with the current financial crisis and therefore restricting it would do little to prevent a replay; and second, proprietary trading provides a very small percentage of bank revenues and therefore is not very important.

The implication of these two points is that it is not really worth the political battle to restrict proprietary trading because it is small and unimportant.

Others argue that failure to “beef up” regulatory proposals will lead to another crash

A third set of arguments has been made by many bloggers, economists and some financial analysts: namely, that Volcker’s very narrow limits would make it easy for bankers to evade the restrictions and, moreover, would allow investment banks and others in the shadow financial world to undertake many risky and dangerous activities that could crash the system and require tax payer bail-outs. This implies that the Volcker Rule would have to be beefed up considerably as well as broadened to include investment banks, hedge funds and other corners of the financial world, in order to truly reduce the risk in the system to acceptable levels and to significantly reduce the likelihood of the need for future massive tax payer bailouts.

Epstein offers evidence that proprietary trading did trigger 2008 crisis 

In this note we argue that the conventional banker wisdom is incorrect. First, proprietary trading, properly defined and contextualized, had a great deal to do with the crisis. We produce several types of evidence to suggest that proprietary investments and trading were large and had a significant impact on the crisis. For example, we cite evidence that by mid-April of 2008 large banks had lost roughly $230 billion dollars on their super-senior CDO [Collateralized debt obligations] proprietary holdings, which regulators and other interested parties believed were simply inventories of assets held to facilitate client trading. If one makes the crude assumption that this represents a loss of approximately one-third of their value, then banks were holding three quarters of a trillion dollars of these highly risky assets. Clearly, proprietary trading, properly defined, was a major cause of the recent crisis. Second, we present rough estimates that suggest that this type of trading and investment was much more important for the bottom line of major banks than has been reported by banks and bank analysts and, subsequently, repeated in the press.

At the same time, the critics are certainly correct that to be truly helpful the Volcker rule has to be significantly strengthened and broadened, specifically to large investment banks and the shadow banking system.

What is the objective of the “Volcker Rule”?

The objective of the “Volcker Rule” is to greatly restrict the ability of financial institutions to engage in highly risky activities that may destabilize these institutions, the financial system, and ultimately the overall economy with tax payer guaranteed funds and at the risk of large taxpayer bailouts. The “rule” is intended to eliminate private equity and hedge fund type risk taking/speculation/gambling that put at risk institutions that have explicit or implicit tax payer guarantees. As stated, the rule would attempt to do this by eliminating these institutions’ ownership of private equity and hedge funds thereby ending their “proprietary trading.” In this context, there is much confusion about how to best define “proprietary trading.”

Clarifying the meaning of “proprietary trading”

Clarification can be found in recognizing that, given the objectives of the “rule,” the term “proprietary trading” is itself a misnomer. The danger to the financial institution is not trading, per se, but proprietary position-taking and proprietary investments. Of course, these institutions may contribute to overall financial instability and risks through the manner by which they conduct “trading” for clients and for themselves, but it is the investments and position-taking that create the dangers and risks to the institutions themselves. When these positions or investments drop in value and/or can no longer be funded because liquidity has dried up, these often highly illiquid investments/positions can rapidly lose value and place the institution at risk. If the bank is very large or highly interconnected, then this dynamic places the overall economy at risk and this “too big to fail” institution then con-fronts the government with bail-out imperatives. As we describe in the next section, this is precisely what occurred in this crisis.

Banks “too big to fail.” Data “too confusing to understand”

Part of the current confusion is also created by the enormously murky nature of the data on proprietary trading and investments as well as the incomes that are generated by these activities. “Trading revenue” is defined in most of the data sources as comprised of three components: 1) trading on own account; 2) trading for clients; and 3) making markets. In fact, all of these components are highly interrelated and all will involve, directly or indirectly, some trading, investments and position taking for the banks’ own accounts. But the data reporting requirements are so lax, that it is impossible for the public, and probably the regulators themselves, to understand the nature and size of these activities. For example, as we discuss below, many proprietary investments are “hidden” in banks’ trading books, disguised as “trading” for clients.

There must be a “revolution in information and accounting transparency”

An absolutely crucial first step to reduce these risks for tax payers and the economy as a whole is this: there must be a revolution in information and accounting transparency. In particular, there must be major changes in accounting standards and greater empowerment of regulators to guarantee real time access to financial institutions’ books in order to better understand the quantity and quality of financial institutions’ proprietary investments and positions.

Proprietary investment and trading helped crash the system

Risky proprietary investments by investment banks, along with trading for clients whose decisions were influenced by these banks, were among the main forces that sustained upward pressure on security prices in the bubble. Indeed, by running large trading books, banks had inside information on client trading patterns and could use that information to front-run, and therefore help sustain, market trends. Moreover, banks borrowed large sums of short-term funds, mostly in the form of repos [repurchase agreements], to leverage their own trading and to loan to hedge funds and other clients whose trades were executed by the banks. Rising leverage to sustain such trading helped create systemic risk.

Inept regulation stimulated piling up of risky assets

More importantly, as market makers, banks maintain large inventories of the securities ostensibly to facilitate trading, but these inventories in fact include substantial quantities of proprietary investments hidden within market-maker inventories. By 2008, bank trading books held hundreds of billions of disguised proprietary investments. The piling up of risky assets on bank trading books was stimulated in part by inept regulation. . . . Gillian Tett, senior capital market analyst of the Financial Times, explained this phenomenon [in a 2008 report] as follows:

“[While] the Basel rules require banks to hold large capital reserves against the risk of credit default in their loan book, regulators only require small buffers for assets held in the trading book if these are labeled as low-risk, according to so-called Value at Risk (VAR) models. Research by supervisors suggests that the proportion of assets held in banks’ trading books has risen sharply in recent years, often to above 50 per cent of those assets, apparently because of the favourable regulatory treatment… In April, the FSF (Financial Stability Forum) said: ‘Global banks’ trading assets have grown at double digit rates in re-cent years, and in some cases represent the majority of a bank’s assets’” (Tett 2008, Plan to make complex debt more expensive — for FT subscribers only).

In a follow-up piece, Tett showed how reckless the giant banks had become in their use of trading-book accounting to pile up risky proprietary investment.

The travails of UBS have served as a particularly painful wake-up call. UBS [a Swiss global financial services company] had quietly stockpiled tens of billions of dollars of so-called super-senior CDO tranches on its trading book, supposedly because it planned to sell these to investors (although it is unclear whether the bank expected such sales to occur.) The bank made little provision against the chance of these instruments turning sour, because the models implied a negligible risk of losses. When the price of these super-senior tranches collapsed by up to 30 per cent late last year, this created more than $10bn (£5.1bn, €6.4bn) worth of trading book losses for which the bank had set nothing aside (Tett 2008, Battered banks face regulators’ harder line on trading books — for FT subscribers only)

Bank losses pile up on “three-quarters of a trillion dollars worth of risky assets”

By mid-April of 2008, banks had lost roughly $230 billion dollars on their super-senior CDO proprietary holdings that regulators and other interested parties believed were simply inventories of assets held to facilitate client trading. These losses probably were created from about three quarters of a trillion dollars’ worth of risky assets. Clearly, proprietary trading was a major cause of the recent crisis.

Proprietary trading and investment is bigger than you think. But press and CFOs mislead the public

Despite these massive losses, within a day or two of the Volcker Rule announcement, the press was full of stories quoting data from bank analysts that proprietary trading was very small and therefore not worth worrying about.

The CFO of Goldman Sachs, David Viniar was quoted by Reuters as saying: “Goldman does have proprietary trading operations, which account for ‘10ish’ percent of its revenues. The analysis in the Wall Street Journal on January 21, 2010 was typical: Proprietary trading makes up about 10% of Gold-man Sachs revenue, 5% of Citi’s, less than 5% of Morgan Stanley’s, and less than 1% for Bank of America and J.P Morgan. Jason Zweig reflected the conventional wisdom when he wrote in the Wall Street Journal, “….it is small potatoes for banks.”

One can understand why banks would want to promote this idea: first, they wanted to protect the value of their bank stocks which had been battered the day the “Volcker Rule” was announced; and second, they presumably wanted to build the case that proprietary trading is so small that it is not worth worrying about.

How to “cook the books” and mislead the public

A closer look at the data suggests where the low-ball estimates may be coming from. It also provides a good benchmark for us to provide estimates of the size of this activity on banks’ revenues. First, . . . the widely reported data are likely to be taken from the crisis years, 2008 or 2009, rather than from the height of the bubble years. But if one is trying to assess the impact of strict rules in preventing future problems, surely the pre-crisis years are more relevant. Second, the quoted shares are of gross revenue rather than of net revenue. Gross revenue is, of course, a much bigger number and therefore will reduce the size of the ratio. But net revenue, is a much more relevant figure because it is net revenue that is divided into salaries, bonuses and profits and that the bankers and stockholders really care about. In other words, it is a much better measure of the bottom line. Third, the widely cited estimates are almost certainly trying to estimate proprietary trading in the most narrow way possible and likely do not take into account the often arbitrary lines that are drawn between own account, client account and market making aspects of trading, position taking and investment.

Epstein’s calculations based on analyses of annual reports yield startlingly higher estimates

We undertook some rough calculations of trading for three banks: Goldman Sachs, Morgan Stanley and Citi. These estimates must be seen as very rough because the data are so difficult to break down, but we believe they accurately illustrate our points.

Consider, first, Morgan Stanley. The data show that in 2008, Morgan Stanley’s trading and investment revenues were about 2% of total revenue as has been widely reported in the press. Note that we are not claiming this is precisely “proprietary trading” as defined narrowly. But the benchmark figure for Morgan Stanley in 2008, at 2% of gross revenue, as well as other estimates below, suggests that our data are in line with the estimates quoted in the press.

Now, note that this 2% figure is from 2008, the year the system crashed. But note that in 2006, at the height of the bubble, income as a share of total revenue was more than 19%.

The next point is that total or gross revenue is not the appropriate revenue figure to look at. It is important to distinguish between total revenue, which does not take into account interest expense, and net revenue, which nets these costs out. Profits for shareholders and bonuses for bankers come from net revenue, not gross revenue. This is the figure that the banks themselves really care about. The ratio of trading income as a share of net revenue was 5.1 % in the year of the crash, it was more than 45% at the height of the boom in 2006.

A similar overall story holds for Goldman Sachs. In 2008, trading income as a share of gross revenue was “tenish” percent as reported in the press by Goldman; more “precisely” according to our figures, it was about 15%. But if one goes back to the boom years of 2006, it was more than a third of the gross revenue, almost 35%. Furthermore, if one uses the superior measure, namely as a percentage of net revenue, trading income’s share in 2008 was 36%, and in 2006 and 2007 was a whopping 64% or more.

For Citigroup, our numbers are even rougher than for Morgan Stanley and Goldman, but they are ac-cutate enough to tell an interesting tale. Trading and investment revenue as a share of gross revenue in 2006, at the height of the bubble, was only about 5% of gross revenue, the number cited by many in the press. If one uses the more appropriate net revenue figure then this share jumps to over 9%.

Interestingly, if one looks at the contributions to Citi’s revenue losses during the crash, according to these admittedly crude estimates trading and principle investments played a significant role. In 2008, for example, trading and principle investment losses amounted to 20% of gross revenue and over 40% of net revenue. If one counts these trading losses as a percentage of the declines of total and net revenue, these numbers become much higher. For example, between 2007 and 2008, Citigroup’s total revenues fell by almost $50 billion and net revenues fell by almost $26 billion. In 2008, they lost $22 billion which amounts to 44% of total revenue losses and more than 80% of net revenue losses.

Contrary to the bankers and pundits that claim that “proprietary trading” did not cause the crisis, it is these losses which led to a tax payer bailout and which, in fact, constitutes what most of us mean by “the financial crisis.”


Trading, and proprietary investments, made a much bigger contribution to bank revenues (and losses) than bankers and the press have suggested. It is virtually impossible to distinguish proprietary trading and investments from market making and trading for clients, which often involve proprietary investments and position taking by the banks. Trying to make highly restrictive definitions of proprietary trading will make it very easy for banks to use accounting gimmicks to move investments, position taking and income to where it is not restricted by regulations. Hence, the Volcker Rule must utilize a broad definition of proprietary trading, investment and position taking if it is going to succeed.

Moreover, as many critics have pointed out, the Volcker Rule must be expanded in other ways as well if it is really going to help reduce systemic danger. Most important is to expand restrictions to investment banks themselves, and to the “shadow” banking and financial world which, despite comments by bankers and pundits to the contrary, did contribute to financial meltdown.

However, none of this will be possible unless there is a revolution in accounting standards and reporting. Regulators and the public do not have adequate information on the quantity and quality of these investments and positions. The only way they will get it is if the accounting standards and reporting requirements are greatly strengthened and complemented by close, hands-on financial examination by regulators. Without this, banks will be able to manipulate trading, investments and positions data around virtually any set of rules that are created.



As noted, Epstein’s paper was published in February 2010. Notably absent from the paper’s Conclusion is his sharp criticism of Federal Reserve Chairman Ben Bernanke, which concludes his 15:46-minute, May 8, 2011 interview on The Real News Network. Here it is —

FAIR USE NOTICEThis blog, Citizen Action Monitor, may contain copyrighted material that may not have been specifically authorized by the copyright owner. Such material, published without profit, is made available for educational purposes, to advance understanding of human rights, democracy, scientific, moral, ethical, and social justice issues. It is published in accordance with the provisions of the 2004 Supreme Court of Canada ruling and its six principle criteria for evaluating fair dealing

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