It's interesting to read the various reactions to the Volcker plan. Some are calling Obama a communist while others are backing it.
Unfortunately there seems to be little by the way of solid detail on the plans, but I agree in principle that something major had to be done. Separating retail and more speculative banking was one way of doing hits. The devil is of course in the detail. One of the best posts I've read on it is here from someone who used to be in the thick of prop trading activity.
"Never mind the issue of if my friend trading merger arb with my
deposits is any more or less risky than his bank instead taking the
money and lending it out to small businesses and homebuyers (cause
that's what they do!) – I think the past few years have cemented the
fact that mortgage lending is not necessarily less risky, but it
certainly looks better on paper, in terms of subjective categories like
benefit to society."
This leads nicely to an interview with Richard Thaler, one of the leading lights in behavioural economics.
Again, another choice quote:
"What was the ultimate cause of the financial crisis? Poor regulation? Greed? Bad market signals? Human frailty?
caused the crisis—and I would say that is a pretty uncontroversial
statement. Human frailty comes into play at two levels. One, the people
who were taking out the subprime mortgage loans—many of them didn’t
understand what they were doing. Two, the C.E.O.s clearly didn’t
understand what their traders were doing. I call that the “dumb
principal” problem. Go down the list—A.I.G., Citigroup, Bear Stearns,
Lehman Brothers. These companies were destroyed or devastated by a
small part of the firm that was hurtling forward and was risking the
entire firm. The people in charge were either greedy or stupid, or
Going back to Kid Dynamite:
"In addition to trying to separate commercial banking and prop trading,
wouldn't a good first step to be to actually separate the commercial
banks from the non commercial banks? People aren't mad because GS is
making money trading – they're mad because GS is making money trading
with what they (the people) think is taxpayer money or taxpayer
The decision to allow non-banks
access to (near zero cost) Fed funds resulted in these non-banks
making extreme amounts of money which angered the populace.
As I said, I fully understand
the desire to implement a situation where commercial banks do not
engage in proprietary trading. However, the real problem isn't
proprietary trading – it's leverage – it's actual risk. Even if/after
we successfully separate proprietary trading from commercial banking,
what are we doing to prevent the next Long Term Capital Management blowup?"
Putting these two together, I personally gain a sense of clarity on the crux of the problem. I hope it helps you.
As the quotes above have inferred, it's not prop trading, it's not bad loans, its any risk that is over leveraged. If Northern Wreck wasn't so dependent (leveraged) on short term funding it may not have have starred in act 1 of the crisis.
Aleph blog has further thoughts on the role of leverage in the crisis
PS an update to my little conspiracy theory. Goldmans could (surprise surprise) be the bank with the most to lose with a ban on prop trading. By extension, you could argue they are one of the biggest market makers out there. By further conspiratorial extension, you could argue that as Goldman's are one of the most active program traders on the NYSE, they have the ability to nudge the market a little here and there.