Regulating Motivation: A New Perspective on the Volcker Rule

Marcel Kahan is the George T. Lowy Professor of Law and Ryan Bubb is Professor of Law at New York University School of Law. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Regulating Bankers’ Pay by Lucian Bebchuk and Holger Spamann (discussed on the Forum here); The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008 by Lucian Bebchuk, Alma Cohen, and Holger Spamann (discussed on the Forum here); and How to Fix Bankers’ Pay by Lucian Bebchuk (discussed on the Forum here).

The myriad problems with the Dodd-Frank Act’s ban on proprietary trading by banks have led to a rare bipartisan consensus: the Volcker Rule must be pared back or even repealed. At the root of the Rule’s problems is a fundamental definitional challenge. Whether a particular trade is banned turns on its motivation—is the trade intended to profit from short-term price movements or is it incidental to core financial intermediation functions such as market marking and underwriting—which is difficult for regulators to determine.

The definitional challenges inherent in the current “define and ban” approach have resulted in a highly complex rule that entails high compliance costs and real risks of both under- and over-deterrence. Existing proposals for reform short of repeal entail tinkering with the same basic approach. We propose a new paradigm for achieving the Volcker Rule’s objectives: rather than define and ban proprietary trading, regulators should simply ban banks from paying traders on the basis of trading profits.

Our proposal takes advantage of the competition between firms in two key markets that are essential to proprietary trading: the securities market and the labor market for traders.

Firms that engage in the type of speculative trading targeted by the Volcker Rule compete in the securities market to identify and exploit trading opportunities. Importantly, however, making bets on short-term price movements of securities is inherently a zero-sum game. This is most obvious in the form of bilateral securities, like a credit default swap. If two parties make opposing bets using a credit default swap, then if the reference security defaults, the buyer will make money on the contract and the seller will lose money—and vice-versa if the reference security does not default. Speculating on short-term price movements of securities is fundamentally similar. The securities market as a whole will generate some total return. Short-term buying and selling of securities only affects who gets what share of that total return.

One implication of the zero-sum nature of speculative trading is that the returns to the activity depend on the relative skill of competing traders. Skilled professional traders compete with each other to seek out profitable trading opportunities generated by investors who trade for non-speculative reasons and by other speculative traders. In order to profit systematically from trading, a trader must be better at predicting price movements than the counterparties with which she trades, which include other speculative traders. The firms that hire and effectively motivate the best traders will generally build profitable trading businesses. Firms that are unable to do so, however, engage in proprietary trading at their own peril.

Reflecting this, the second key market in which firms that engage in proprietary trading compete is the labor market for traders. Both banking entities covered by the Volcker Rule and financial institutions outside of its scope, such as hedge funds, compete to hire the best traders. A common incentive compensation regime used to attract and motivate traders—employed by both hedge funds and by proprietary trading desks at banks—pays the individual trader a fraction of her trading profits. Such incentive compensation serves both a screening and effort-inducing function. More talented traders are more willing to take such incentive contracts because they are more confident that they will produce the trading profits needed for a big payday; and traders will have strong incentives to exert effort to identify and exploit profitable trading opportunities on behalf of the firm.

To achieve the objectives of the Volcker rule, we propose that banks be prohibited from basing compensation on trading-based profits. Our prohibition would encompass both ex ante compensation on trading-based profits (such as contracts or non-legally binding representations that the individual’s pay will be tied to their trading profits) and ex post compensation (such as discretionary bonuses the amount of which set based on a trader’s trading profits). Violations of this rule would result in a fine to the entity, claw-back of the individual’s impermissible incentive pay, and potential criminal liability for intentional violations.

Our proposal is based on a simple insight that follows from the competition between proprietary trading firms. Prohibiting banking entities from paying individuals based on their trading profits would put them at a substantial disadvantage to unregulated entities like hedge funds in the labor market for traders. Because of the zero-sum nature of betting on short-term price movements, firms that can only attract sub-par traders—the “B-team”—do not merely stand to make lower profits than firms with traders in the A-team, they stand to make losses. Put simply, if a firm cannot attract and motivate the best trading talent, the firm is better off staying out of the speculative trading game altogether. Thus, banning banking entities from paying individuals based on their trading profits would create powerful incentives for banks to cease such trading.

Our simple compensation-based approach would likely be more effective at ending speculative trading at banks—and do so at lower cost—than the complex and loophole-ridden current approach. Under the define-and-ban approach, banks would still want to engage in speculative proprietary trading, but are constrained by the fear of liability if they engage in such trading that violates the rules and their activities are detected. Banks will thus have incentives to exploit gaps and ambiguities in the define-and-ban regime to engage in speculative trading that is, at least arguably, not prohibited as well as to conceal the true nature of any speculative trading from their regulators. These incentives, in turn, necessitate the complex regulation and costly enforcement that characterize the current regime.

Under our compensation-based approach, by contrast, banks will no longer want to engage in speculative trading. Banks will thus come up with their own schemes to control the trading activities in their market making, hedging, and underwriting operations. Moreover, if traders will not receive compensation based on their trading profits, they will likewise lack incentives to engage in underhanded speculative trading. Engaging in such trading, against bank guidelines, would not earn, say, a market maker higher pay, but may lead her to lose her job. A bank’s incentives and ability to inhibit speculative trading under a ban on profit-based compensation are thus much stronger than under the define-and-ban approach.

An additional advantage of our approach is that enforcement of the ban on compensation-based profits need not be absolute to achieve the Volcker rule’s objectives. As long as a trader does not anticipate receiving a share of her trading profits, even a compensation scheme in which traders turn out to receive a share of profits will not have the screening and effort-incentive functions the bank desires. And as long as the ban substantially reduces the percentage share of profits that a trader expects to receive, a bank will be at a significant competitive disadvantage in competing for the best traders with unregulated entities. Even a relatively simple enforcement regime that fails to deter some ex post profit-based compensation will suffice. Our compensation-based approach is hence likely to be both simpler and more effective than the current define-and-ban approach.

The complete paper is available for download here.

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