Hey Buddy, I'll Swap You Some Prop

The plan to rein in the beaten down banks makes no sense.  As a seven year old, I had a poster on my bedroom wall from some ancient paper mill, printed on very nice 100% rag paper that said:

Rags make paper,
Paper makes money,
Money makes banks,
Banks make loans,
Loans make beggars,
Beggars make rags...

I think that was my first understanding of a ponzi scheme, however mis-guided.  A bank is a state sanctioned ponzi scheme.  I'm only half kidding.  Banks collect deposits based on a promise to pay their customers cash when the customer come looking for the cash.  The bank doesn't hold the cash.  The bank lends the cash.  If they're lucky, they lend it to someone who deposits it back with them. 

In any case, the bank makes loans that it probably cannot "call" (demand repayment) in the same timeframe that it's depositors can demand their cash back.  So, the bank holds a cushion of capital.  This fundamental asset / liability mismatch with a slug of cash to bridge the gap is what we commonly call a "bank".  When something goes wrong, the government steps in, via FDIC, with very deep pockets.

So, banks explicitly take risk based on the difference in liqudity, credit quality, etc. between their assets and liabilities.  These activities presumably reflect the smarts and skills of the banks management.  So, how do you differentiate between these differences being "proprietary trading" and "lending"?  You can't, and here's why.

First and foremost, the modern financial markets have succeeded at reformulating ANY risk into a loan.  I call this the Mother of All Swap Meets.  Swaps historically developed to allow risk managers and traders to trade floating rate interest payments for fixed rate payments.  However, bankers soon learned that anything could be swapped for anything else.  Oh, and people prefer things that look fixed, even though the fundamental risk is floating.  You could re-package very risky activities into things that looked like stable, fixed payments, until they blew up in your face.  I think this is now common knowledge...three years too late.

So, what does it mean to halt prop trading?  Commercial banks may only make loans?  Great!!  Instead of directly engaging in risky behavior that may generate good returns, you lend money to those who engage in risky behavior.  That stinks.  You hold the downside, and get none of the upside.  This is my problem with most fixed income investing, (see this and this.)  Also, once you are a step removed from the risky behavior, you cannot possibly understand it as well.

The problem remains: As long as you are going to allow banks to make a profit based on an asset/liability mismatch of any significance, you run into the problem that you cannot separate the risk of prop trading from the risk of lending, and the lending risk only has bad news.

This concept is nice in theory, but in practice, it's no better than the extreme measure of 100% reserve banking.  Smart people of the financial world will always repackage risk taking into loans.  If you don't separate banking from risk taking, you're just splitting hairs. 

But wait, you say, if banks can't make loans, where do you get a loan?  From the capital markets.  A finance company that is not subsidized by an unlimited promise from FDIC.  The equity and debt holders of finance companies take responsibility for what they do with there money, and they monitor the risk taking of the firms in which they invest.  Yes, your will still get your loan.