President Obama’s Banking Proposal

(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.

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