On “proprietary trading” and commercial banks

“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.” — Kid Dynamite

Well, precisely.  What is a bank, but leveraged finance?  When commercial bank deposits are used to finance prop trading, the leverage is about 20:1, so any substantial position that loses more than 5% can provide a serious hit to a bank’s equity capital and create a headache for regulators.

And it’s a fact that the rehypothecation of prime brokerage collateral played a role in both Bear Stearns’ and Lehman’s collapse — and while holding collateral is clearly essential to client services, it seems to me that that when a broker chooses to use clients’ collateral in order to finance the broker’s business, this rehypothecation is proprietary trading.  Ergo proprietary trading played a large role in the financial crisis.  — And don’t tell me that there were no prime brokers supported by commercial banks that failed, because we all know that without a government bailout Citigroup was bankrupt.

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