Rather than demanding an end to default-prone subprime lending funded with hair-triggered short-term debt, bank critics have, ironically, demanded an end to proprietary trading, which they view as unnecessarily risky, but which was inconsequential to the cause of the Crisis. In a world where banks underwrite and trade risk, what constitutes proprietary trading? When a bank takes credit-default risk by making aloan, is it taking proprietary risk? It is, without a doubt. But loaning money is what banks do. When a bank like Goldman Sachs seeks to unwind that risk by shorting mortgages prior to the downturn, is that proprietary trading? Yes. So is borrowing short and lending long. With banks now primarily underwriting, pricing, and trading risk rather than merely funding loans, restrictions on proprietary trading unnecessarily imperil banks and distort capital markets to restrict banks to only the long side of the trade. restricting banks to long-only positions substantially increases withdrawals in the event of a panic.
I would stress that the real problems come when the overwhelming majority of banks go heavily long on some fairly simple assets — usually real estate — in an overly optimistic way. Think Ireland, Iceland and the United States during the last crisis, among many other instances. Once the short-term debt behind those banks starts to unravel, all hell breaks loose and the central bank can at best limit but not stop the carnage. That is the main problem financial regulation should be trying to address and it isn’t easy.
I am much less worried about “rogue trades” or “rogue investments” at individual banks (or non-banks), even very large ones. Such trades surely exist: think LTCM or even Continental Illinois. Ex post, there is usually a way to plug the gap, if only by having the Fed backstop a deal. After all, the rest of the banking system is sound in these scenarios. Prop trading may increase the chance of this second problem, but arguably it decreases the chance of the first and larger problem.
You can buy Conard’s stimulating book, Unintended Consequences, here. Conard, by the way, does object to how the government implicitly subsidizes the short-term debt of the major U.S. banks and he views that as the root of the problem behind proprietary trading, not the trading itself.