Glass-Steagall lite: Barack Obama proposes limiting the activities of big banks

Obama and the banks

Glass-Steagall lite

Barack Obama proposes limiting the activities of big banks

Jan 22nd 2010 | NEW YORK
From Economist.com

REUTERS

IT IS a fair bet that one of Barack Obama’s new-year’s resolutions was to rattle Wall Street. A week after hitting America’s largest financial firms with a “responsibility” fee, to recoup up to $120 billion in bail-out losses, on Thursday January 21st the president proposed dramatic new curbs on their activities. Keen to show progress in at least one part of his agenda, especially after an election in Massachusetts stripped the Democrats of their super-majority in the Senate and put health-care reform in doubt, Mr Obama touted the plan as a way to cut the bloated giants of finance down to size and constrain excessive risk-taking with customer deposits. “Never again will the American taxpayer be held hostage by a bank that is too big to fail”, he thundered.

The implausibility of that claim should not detract from the potential impact of the plan. Though not a full return to Glass-Steagall, the law that separated commercial banking and investment banking in the wake of the Great Depression (and was repealed in 1999), it is at least a return to its “spirit”, as one official put it. Reflecting the possible dent it could put in profitability, bank shares tumbled, pulling stockmarkets down sharply around the world.

The first half of the plan concerns restrictions on the scope of activities. Banks that have insured deposits, and thus access to emergency funds from the central bank, would not be allowed to own or invest in private equity or hedge funds. Nor would they be able to engage in “proprietary” trading—punting their own capital—though they could continue to offer investment banking for clients, such as underwriting securities, making markets and advising on mergers.

The second part focuses on size. Banks already face a 10% cap on national market share of deposits. This would be updated to include other liabilities, namely wholesale funding. The aim is to limit concentration, which has increased greatly over the past 20 years, accelerating during the crisis as healthy banks bought sick ones. The four largest banks now hold more than half of the industry’s assets.

These proposals will be wrapped into a broader set of reforms that is grinding its way through Congress. A bill passed by the House of Representatives, but not yet taken up by the Senate, gives regulators the right to limit the scope and scale of firms that pose a “grave” threat to stability. The new plan goes further, requiring them to do so. It is also more radical than the increased capital charges for trading assets proposed by the Basel Committee of international bank supervisors.

The administration had until now seemed content to shackle the banks with tougher regulation, including higher capital ratios, rather than breaking them up or limiting what they could do. But it has warmed to the thinking of Paul Volcker, a former Federal Reserve chairman and Obama adviser, who has long advocated more dramatic measures—indeed, Mr Obama dubbed the latest reforms “the Volcker rule”. Intriguingly, the rethink was prompted as much by banks’ behaviour over the past year as by their pre-crisis sins. In explaining their rationale, officials pointed to the fat profits some banks made in capital markets in 2009 while benefiting from state guarantees. On the same day as the plan’s unveiling, Goldman Sachs reported better than expected results, thanks largely to outsized investment-banking fees.

With details yet to be hammered out, the plan’s effects are hard to gauge. Commercial banks may be unfazed by curbs on trading. Most have already pared their prop-trading desks. JPMorgan Chase derives a mere 1% of its revenues (and 3-5% of its investment bank’s) from such business. But having to divest Highbridge, a big hedge-fund firm, would be “horrible”, says a JPMorgan insider. The bank thinks that may not be necessary since its capital is not invested directly in Highbridge’s funds. But no one is sure.

Things could be trickier for investment banks that became bank holding companies during the crisis. Having built up its deposit base, Morgan Stanley would face a hard choice between remaining a bank and going back to being a broker that can trade freely. Goldman, which gets 10% or more of its revenue from prop-trading, will surely do the latter. That raises an awkward question: once it is cut loose from banking restrictions, and from Fed funding, would it not continue to enjoy implicit state backing? Would it really be allowed to fail if it blew up? Officials argue that other reforms, such as central clearing for derivatives, will make it easier to let such firms die. Convincing markets of that will be difficult.

Enforcement could be tricky, too. Regulators will struggle to differentiate between proprietary trades and those for clients (someone is on the other side of every trade) or hedging. Getting it wrong would be counter-productive: preventing banks from hedging their risks would make them less stable.

Moreover, the plan is unlikely to help much in solving the too-big-to-fail problem. Even shorn of prop-trading, the biggest firms will still be huge (though also less prone to the conflicts of interest that come with the ability to trade against clients). As for the new limits on non-deposit funding, officials admit that these are designed to prevent further growth rather than to force firms to shrink.

They may, in any case, be pointed at the wrong target. Curbing the use of deposits in “casino” banking is an understandable impulse, but some of the worst blow-ups of the crisis involved firms that were not deposit-takers, such as American International Group and Lehman Brothers. And much of the losses stemmed not from trading but from straightforward bad lending (think of Washington Mutual, Wachovia and HBOS).

That just leaves the question of whether the plan will make it through Congress. Scott Garrett, a congressman, captured the mood on the resurgent right when he branded the proposals “a transparent attempt at faux populism.” Republicans are torn between distaste for government heavy-handedness and reluctance to be seen giving scorned bankers an easy time.

Mr Obama certainly cannot be accused of going soft on moneymen. In December, Mr Volcker complained that the reforms proposed so far had been “like a dimple.” With his eponymous rule now on the table, he has changed his tune.