(Update: I did not want to add my own reaction until I had a chance to read through the President’s speech. In quick terms, I think it is conceptually the right approach, for the reasons laid out by Manzi, McArdle, today’s WSJ editorial, but above all by Paul Volker. It is important to understand that this new Volkeresque proposal, as a regulatory matter, is altogether in a different world from the faux-populist banker bonus taxes under discussion; some aspect of them might well be politically necessary and well-justified, but no one can think that such theatrics constitute regulatory reform of too-big-to-fail and moral hazard. Moreover, the WSJ editorial is correct to note that even if one accepts, as I do, that the idea of separating out proprietary risk taking from government-underwritten commercial banking, the devil is mostly in the details for how one separates those activities at the level of proprietary trading versus, for example, market-making on the behalf of clients. Still, I have long thought Volker right in principle, and I congratulate the President and the administration for having the guts to go there. I hope they see it through, and I hope Republicans see the virtue of this. PS – the FT has excellent discussion of this today.)
I was interested to see that self-described center-right-libertarian Jim Manzi, over at NRO, has endorsed the broad concept behind President Obama’s recent banking regulatory reform proposals (here’s a description from the WSJ news pages; text of the President’s address is here at the WSJ’s Deal Journal; article at WSJ Real Time Economics blog describing mixed economist reaction is here). Manzi says, of a proposal where the WSJ front page quite accurately headlined it as “New Bank Rules Sink Stocks: Obama Proposal Would Restrict Risk-Taking by Biggest Firms as Battle Looms”:
The first, and core, concept of the proposal is the re-segregation of commercial banking from proprietary trading (or roughly what used to be called commercial banking from investment banking). This is an excellent proposal … I have been arguing for more than a year that this was the direction financial regulation needed to go, and that the logic of the situation would drive us here. The reason why is straightforward.
Finance professionals, like members of all occupational categories, attempt to build barriers that maintain their own income. One of the techniques used is to shroud what are often pretty basic ideas in pseudo-technical jargon. The reason that it is dysfunctional to have an insured banking system that is free to engage in speculative investing is simple and fundamental. We (i.e., the government, which is to say, ultimately, the taxpayers) provide a guarantee to depositors that when they put their savings in a regulated bank, then the money will be there even if the bank fails, because we believe that the chaos and uncertainty of a banking system operating without this guarantee is too unstable to maintain political viability. But if you let the operators of these banks take the deposits and, in effect, put them on a long-shot bet at the horse track, and then pay themselves a billion dollars in bonuses if the horse comes in, but turn to taxpayers to pay off depositors if the horse doesn’t, guess what is going to happen? Exactly what we saw in 2008 happens.
If you want to have a safe, secure banking system for small depositors, but don’t want to make risky investing illegal (which would be very damaging to the economy), the obvious solution is to not allow any one company to both take guaranteed deposits and also make speculative investments. This was the solution developed and implemented in the New Deal. We need a modernized version of this basic construct, and as far as I can see, this is what President Obama has proposed.
Megan McArdle broadly concurs. She calls it (perhaps hopefully), “The End of Moral Hazard?”:
The administration’s new proposal has two core pieces, both of which are at least somewhat novel. First, banks that have access to the discount window will not be able to trade for their own account. That means no prop trading desk. No owning hedge funds or private equity funds. No investments of any kind to make profits for your shareholders. Financial institutions can make profits by servicing clients, or they can make profits by investing for their own book. But they can’t do both.
Senior administration officials I spoke to made it clear that this would not include market making activity, which the administration views as something you do for your clients. But while that may partially reassure banks, that seems to mean that market makers–i.e. Goldman Sachs–are very definitely included … Indeed, if they pass this thing, they should probably call it the Hey Goldman Sachs! You’re Not Going to Be So Profitable Any More Act of 2010.
The second proposal is to extend something like the caps that already prohibit banks from holding more than 10% of federally insured deposits, to other kinds of liabilities. I asked, but got no clarity, on what exactly this means. Are regulators going to swoop in whenever a diversified financial institution has too big a share of the total liabilities in all US debt markets? Or are they going to intervene when a bank becomes dangerous to one particular debt market, the way Lehman turned out to be in commercial paper? ….
Now, as to the merits of the policy: is it a good idea? On first pass, I’m going to say tenatively yes. The government is recognizing that banks “paying back” the funds they were given is essentially meaningless, because they’ve still got a very, very valuable implied government guarantee. One could argue that they’ve had it since 1991 when the Federal Reserve got the power to loan money to investment banks in extremis. But since last fall, it’s the next best thing to explicit. That means the government needs to take steps to mitigate its own risk.
The way you do that is to decouple the key operation the government insures–the funneling of credit from those with money to those who want to borrow it–from making bets on market outcomes that can go badly wrong. And to ensure that no institution has enough liabilities to take down the system if it fails. That said, I’m not necessarily confident that this is going to work. I’m not even sure that I understand how it will work at this point.
Manzi concludes his discussion with a somewhat hopeful, perhaps overly optimistic take on the politics of the situation – one that, perhaps, underestimates the power of Congress to be bought off by various special interests. (I would assume that its preferred solution would be closer to (a) impose fairly modest but theatrical populist taxes on bank bonuses (b) not actually rein in the financial services sector save in cosmetic ways (c) preserve some kind of direct conduit for rent-seeking in the form of GSEs like Fannie and Freddie to funnel public money and take in campaign contributions and (d) continue to get financial services industry donations in large amounts.) Concludes Manzi:
The political aspects of such reform are compelling. People are disgusted at recent bank bonuses. I’m a right-of-center libertarian businessman, and I’m disgusted by them. Make no mistake, many banking executives right now are benefiting from taxpayer subsidies. Even if they pay back the TARP money, the government has demonstrated that it will intervene to protect large banks. This can’t be paid back. And this implicit, but very real, guarantee represents an enormous transfer of economic value from taxpayers to any bank executives and investors who are willing to take advantage of it. Unsurprisingly, pretty much all of them are.
The “populist” observation that the fact of a bunch of well-connected guys each pulling down $10 million per year while suckling on the government teat constitutes almost certain evidence of self-dealing is accurate, and all the fancy finance talk in the world can’t get around it. President Obama has a clear political incentive to pursue this proposal. I assume Republicans will see that they have a clear political incentive to go along, rather than standing up for such a situation. Hopefully, this will create the political dynamic that will allow real, positive reform.
Finally, I’ll just note this WSJ article noting that Paul Volker, who long appeared to be sidelined in these discussions, while arguing strenuously for a separation along these lines, appears to have won the conceptual day in what amounts to a policy pivot for the administration. It’s a very interesting article describing how that came about.
The policy’s evolution took months, according to congressional and administration officials. Prompted by the cajoling of former Federal Reserve Chairman Paul Volcker and other respected voices, dissenters in the administration—notably Treasury Secretary Timothy Geithner and White House economics chief Lawrence Summers—gradually dropped their opposition ….
On Thursday, Mr. Obama proposed a plan that would prevent banks that receive a federal backstop from investing their own money in financial markets—what is known as proprietary trading. He also pushed for new limits on the size and concentration of financial institutions. Both moves echo the Glass-Steagall Act, the Depression-era banking curbs that was repealed in 1999.
The proposal marked the return of Mr. Volcker to center stage in the Obama White House. The 82-year-old chairman of the president’s Economic Recovery Advisory Board consulted closely with Democrats in the House and Senate as they drafted their proposals to address “too big to fail” entities, referring to financial behemoths whose collapse might bring down the economy. Mr. Volcker spoke frequently with Mr. Obama as well.
But he faced a philosophical divide with others on the economic team …. In talks with his financial team, Mr. Obama started letting his frustration show, asking why he was on the wrong side of the “too big to fail” debate.
White House officials said the president called a meeting of his entire economic team to press for additional proposals. But its members were at odds: Messrs. Geithner and Summers argued that proprietary trading was a problem but not a central cause of the financial crisis, according to an official familiar with the talks. Mr. Volcker saw proprietary trading as a fundamental risk.
In December, Mr. Obama decided he wanted to be on what he saw as “the right side” of the debate, according to an administration official. He asked his team to bring him specific proposals to limit the size of financial institutions and halt proprietary trading. Spurring their thinking: Goldman Sachs had sought the protection of the Federal Reserve during the financial crisis, and was now making big profits from its own trading, in part because it benefited from the explicit backing of the U.S.
It was a big step for the administration. White House economists argued that transparency and disclosure alone could shape Wall Street behavior. But Mr. Obama was now on Mr. Volcker’s side.
Update: It is also quite important to add here McArdle’s observation that many of the relaxations of the line between these activities were justified on the grounds that the regulations made New York less competitive as a banking and money center globally. She correctly says that reimposition of such lines will make New York less globally competitive:
If we do choose this “something”, Americans should probably be clear that this is going to deal a major setback to New York as a world financial capital. Many of the rules that were undone in the last two decades were got rid of because they were making it too hard for American banks to cope with foreign competition. If we do this, America’s financial sector will shrink, and our banks will lose a lot of business to foreign firms. That means, among other things, that we are going to lose big chunks of tax revenue, because bankers are very disproportionate contributors to federal coffers. It also means that New York’s renaissance will probably slack off–and the people who complain about the bankers will discover how many city services those banker salaries paid for.
I believe McArdle is right. I would add, however, that in the long run, the move to re-impose moral hazard regulation might – I hope would – increase the general stability of the US capital markets, and over the long term (it will a long time after having trained the bankers so thoroughly in externalizing their risks, I imagine) have the effect of reducing uncertainty with regards to capital markets and flows through New York. London might well gain in the medium term, likewise other places – but they might also be significantly more unstable over the long run, and encourage a return to New York.
For that matter, McArdle’s final blog point, that the financial sector in the US had got too large anyway – well, that applies even more to London and the UK economy. In a place like London, it might translate into much greater instability in moments of crisis. Competitive pressures on London might turn out to mean accepting more risk and moral hazard for the sake of remaining a competitive industry that sustains much of the rest of the your national economy. The relative size of the financial services sector in Britain arguably suggests this (I don’t have time now to provide links), at least by comparison to the vastly more diversified US economy.
How does that risk express itself, however? Again, arguably, in Taleb distributions – it all goes swimmingly, so to speak, until you drown. How many times, in order to remain globally competitive as a financial center, can the UK public fisc swallow the occasional disastrous meltdown? Meanwhile, a less competitive, but also less competitively pressured, New York financial center gradually acquires a reputation for stability in the much longer term, fewer political uncertainties because the moral hazard does not exist in the first place … might work. Of course, might not.
Per Son says:
I dig the proposal. Firms would still be able to engage in commercial and investment banking as long as it is on behalf of customers. Proprietary trading is still allowed, but you cannot engage in the other stuff. So you can still underwrite investments, just not your own.
I admit it is a little more complicated than that, but it boils down to the fact that when proprietary trading profits, the firms/shareholders enrich themselves. When it fails and money must be taken to shore up the failure from the customer/depositer base – FDIC comes around. In other words, private gain but public cleans up the mess.
January 22, 2010, 11:25 amDavid Schwartz says:
Government regulation never created a problem even more government regulation couldn’t solve.
This regulation would make sense if FDIC insurance was purely opt-in. You can’t get fire insurance if your house has no fire alarms, I get that. But my understanding is that all savings accounts are FDIC ensured, period. I’ve been unable to find out if this is required by law. Perhaps someone can enlighten me.
January 22, 2010, 11:36 amJ Burns says:
I have no expertise in this area, but here’s what I don’t understand. If you look at what happened in 2008-2009, pure commercial banks failed (WaMu, IndyMac); pure investment banks failed (Lehman, Bear Stearns) or were converted into bank holding companies, that is, became commercial bank-investment bank combos (Morgan Stanley, Goldman) in order to save them; and the commercial bank-investment bank combos (Citibank, Wachovia) were used to absorb the failed commercial banks and failed investment banks.
I’m not arguing that nothing was wrong with the regulatory system or that nothing should change (I just don’t know enough), but given that the commercial bank-investment bank combos are the ones that survived, it’s hard to see how having commercial bank-investment bank combos is facially bad.
January 22, 2010, 11:38 amLongwalker says:
J Burns. Easy question. Normally, responsible legislators would act to strenghten the banking ystem. As the commercial-investment bank combos survived better than either the strictly commercial banks or the strictly investment banks, you would assume that the new banking rules would favor thwe combos. After all, the old military rule “re-inforce success not failure” applies to finance as well. But the Democrats, led by President Obama, are either innocent or ignorant about finance. Thus their attempt to reinforce failure.
January 22, 2010, 11:51 amskeptic says:
The merits of this proposal are beside the point. There is no way that this or any other proposal made by Obama will get enacted. Republicans will stonewall and find some aspect of it they can demonize (my guess is they will link it to Fannie/Freddie). Democrats will dither, compromise and then collapse. Most probably Schumer, Rangel and the New York dems will probably not even let it get past committee.
January 22, 2010, 11:54 amS Gray says:
Separating proprietary trading from commercial trading seems sensible, but it’s naive to think that this will somehow protect our financial system from collapse. Many of the most catastrophic financial events of the last 10 or so years (Long Term Capital Management, Fannie Mae/Freddie Mac, AIG) had more to do with the fact that markets were extremely liquid and firms were slicing and dicing investments and shuffling them around electronically using algorithms that were predicated on dubious assumptions (like that Russia wouldn’t default on her debt, or that housing prices would always go up). Regulating the financial system to protect against future problems means recognizing the tradeoff between efficiency and risk. Sure, we can increase capital requirements and restrict risky, lucrative trading and probably end up with fewer financial collapses. the question is whether or not that safety is worth what it costs us in restricting the ability of the market to efficiently allocate resources. I, for one, think that the restrictions aren’t worth the price.
January 22, 2010, 11:58 amPer Son says:
This regulation would certainly allow commercial/investment bank combos, just not ones that engage in proprietary trading.
January 22, 2010, 12:01 pmJavert says:
This statement reveals a shocking ignorance of FDIC insurance, in particular, and of banking insurance, in general.
First, it is neither the government nor the taxpayers who pay for the premiums on FDIC insurance, and therefore neither are the guarantors of deposits. The banks are forced by the FDIC to pay those insurance premiums. In fact, because of this, the well-managed banks end up bailing out the poorly managed ones.
Second, without such (coerced) insurance, there would not be “chaos” and “uncertainty.” There has long been private insurance for banks, and pooled policies to distribute the costs and risks across many institutions. The choice is not: FDIC versus nothing. It is the (coercive and inefficient) FDIC versus the likes of (voluntary and efficient) Lloyds of London.
The only thing the FDIC does is sacrifice the wealthy the productive banks (and their customers and shareholders) to the losers.
January 22, 2010, 12:11 pmPer Son says:
I stand corrected, so I’ll slightly change my statement. Consumers pay the premiums through banking costs.
Taxpayers also pay via bailouts whether they be the S and L crisis or the recent events.
January 22, 2010, 12:20 pmpc says:
e.g., AIG.
January 22, 2010, 12:34 pmPJens says:
I find it puzzling that the president is trying to sell this good idea by demonizing Wall Street and banks. A better approach may be to try and point out the benefits of such changes. I agree with the post, and note the cost of stability will be decreased investment.
January 22, 2010, 12:37 pmMark Buehner says:
Funny, last year they were strong arming these guys into consolidation. Wouldn’t be funny if it were me…
Its a good policy though, but it probably doesn’t go far enough. Unlike Glass-Steagall, the banks can keep their investment houses so long as the finances are separated by a fire wall. Of course if we know anything about financial fire walls its that they instantly burn down.
I don’t think there will be much Republican opposition- but there will be a lot of Corporatist opposition and a lot of those guys are Obama employees. That will be interesting. I’m glad Obama did this if for no other reason you can see the cockroaches scurrying.
January 22, 2010, 12:40 pmAnon21 says:
A “better approach” how? Not politically, surely.
That’s charmingly naive. The Republican Party is a bought-and-paid-for subsidiary of the financial industry.
January 22, 2010, 12:49 pmJardinero1 says:
The reforms are useless.
If you consider that a banks primary duty is to accept deposits and make loans on homes and real estate then nothing which Obama proposes would have averted the present crisis or prevent another one. The banks have balance sheet issues because their assets, i.e. loans are mostly backed by collateral, i.e. houses that are declining in value.
The fact is that the bankers made bad decisions about who they made loans to. Any proposal that doesn’t provide a penalty for bad decision making is not worth pursuing. The only realistic way to encourage prudent decision making and punish bad decision making is to allow for bank failure.
January 22, 2010, 1:01 pmAdam J says:
Longwalker- “As the commercial-investment bank combos survived better than either the strictly commercial banks or the strictly investment banks”
Problem is, they didn’t survive better, they only managed to survive by relying on the commercial bank as a cushion until the bailout occurred. That’s not better, that’s just a little longer, and they would have done alot more damage then either Bear or Lehman to the economy because of their combination had they completely failed. And the banks used this threat of collateral damage to coerce a ridiculously generous bailout for themselves. As to commercial banks, sure some failed (the ones that primarily acted as subprime loan originators)- but we didn’t need to bail them out to save the economy and universally commercial banks did far better then investment banks, all of which required government assistance to survive.
Javert- I dunno, I think your ignorance is astounding as well- FDIC payouts don’t bail out banks, FDIC takes over the bank, liquidates it and pay out depositors. And depositors are certainly the ones who pay for FDIC insurance, it comes right out of our interest rate. I’m also confused by your point, insurance, by its very nature, is a business in which the successful bail out the unsuccessful. I’m certainly not opposed to private competition with the government for insurance, but a suggestion that it will be more efficient is pure speculation- I would think the FDIC possesses a tremendous economies of scale efficiency.
January 22, 2010, 1:03 pmMark Buehner says:
I guess we’ll see. Whats Tim Giethner have to say about that?
January 22, 2010, 1:19 pmAnon21 says:
There are certainly Democrats who are bought-and-paid-for as well, but all the Republicans are. As to Geithner himself, he appears to have just lost a major policy battle, and may even (cross your fingers) be on his way out.
January 22, 2010, 1:28 pmMark Buehner says:
Uh huh. Like I said, I guess we’ll see who’s bought and paid for. Dems dont need much help, that’s for sure.
January 22, 2010, 1:34 pmPedant says:
Er, it’s Volcker
January 22, 2010, 2:19 pmbartman says:
But the Democrats, led by President Obama, are either innocent or ignorant about finance. Thus their attempt to reinforce failure.
Paul Volcker is ignorant about finance, that’s what you’re saying, right? (BTW, Anderson, note the spelling of Volcker.)
January 22, 2010, 2:28 pmMark Buehner says:
The WSJ comes out in general support of the plan. Godless pinkos that they are.
edit- my spelling is so bad i cant even abbreviate correctly.
January 22, 2010, 3:31 pmPedro says:
I am no fan of big government but I’m digging the push for regulation here. The days of the O.K. Corral and shoot-from-the-hip banking have to stop. However, in light of the paralyzed health-care reform bill, I’m skeptical that effective regulations will ever be put in place.
I think a change in “the process” needs to happen in the ivory towers of Washington for there to be “change we can believe in”. -lol
-P
January 22, 2010, 3:37 pmhttp://www.whoneedslawyers.com
Allan Walstad says:
Obama versus the banks? Sounds like a lovers’ quarrel to me. Pols, both Dem and Repub, are in bed with Wall Street. “To big to fail” is the excuse for bailing out the insiders. The elephant in the room is the Fed itself, jerking around wildly with the money supply and interest rates, creating bubbles that bust, then blaming it on anybody but themselves. Pols need the Fed (the way the addict needs drugs) because a stable money supply based on gold or other commodities would make it harder for them to spend wildly whenever the urge arises.
…and none so chronically as Fed chairs.
January 22, 2010, 4:06 pmManju says:
This is absolutely correct. A myth has been born that the repeal of Glass-Steagel lead to the creation of banks that were too big to fail, therefore we had to bail them out. But not only did virtually every instiution that went or was close to going belly up exist in pre-glass form, it was the megabanks that provede them with stability.
JPMorgan, a combined Inv and commerrcal bank, provided a home for independet Ibank Bear. BOA (combined bank) saved independent ibank merrill and only really got into trouble b/c of Merrill. independet ibank lehman went under as did a slew of pure commercial banks, starting with the subprime lenders, as did lesser known hedge funds, also independent. AIG was an insurance company and had nothing to do with the repeal. Ditto for the GSEs, fannie and freddie. Citi was the only post glass-steagal megabank that failed (or would have failed w/o a bailout).
January 22, 2010, 4:55 pmMark Buehner says:
I don’t think it was a question of whether they existed, but what they were doing, particularly the risk they were taking on.
January 22, 2010, 5:28 pmCrazyTrain says:
Until last year, almost all money market accounts were NOT FDIC insured. Only when some of them began to “break the buck” did the government step in and require them to be insured in the short term.
January 23, 2010, 1:11 amEric Rasmusen says:
As some of the commentors have noted, it looks as if the proposed changes have zero relation to the problems we saw in the financial crisis. Rather, it seems that they’re designed to make use of words like “bank” and “private equity and “hedge fund” to pretend that evildoers are being thwarted. I wonder if this is designed, too, to help some people on Wall Street at the expense of others. Who there gains from this? I suppose the winners include hedge funds that won’t have to compete with bank-owned hedge funds.
Part of this is the general strategy of making sure that the blame goes on the private banks rather than on Fannie/Freddy and the regulators who permitted and even encouraged the banks to make risky loans.
January 23, 2010, 1:47 amPintler says:
I don’t think so, in theory anyway. For example, the FDIC has a page where you can check whether a given bank is FDIC insured.
In practice, I think non FDIC insured domestic banks are quite rare, but AFAICT, federal law doesn’t preclude opening one. State laws might require it, I suppose?
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