Financial Regulatory Forum

SCENARIOS-How Obama’s bank reforms could affect banks

By Reuters Staff
January 22, 2010

NEW YORK, Jan 21 (Reuters) – U.S. President Barack Obama is looking at limiting risk-taking at banks.

But his proposals on Thursday were tantalizingly vague. He said he wanted to limit the amount of borrowing that banks can do relative to their peers and limit their trading activities to buying and selling securities to customers.

But it is not clear whether relative borrowing limits will be low enough to force banks to reduce their debt. And the line between buying and selling securities on behalf of customers, and doing so on behalf of the bank, can be blurry.

The White House has also said it wishes to prevent banks from investing in and sponsoring hedge funds and private equity firms, but it is not clear if banks will also be prevented from financing these clients, which can itself be risky.

Wall Street firms are likely to fight any efforts at reform, and President Obama has lost some political capital after a bruising effort to pass health care reform, and losing a Senate seat in a special election in Massachusetts.

Any legislation will take months if not years to wind its way through Washington, and predicting how it will the law will end up working is difficult. But here are some possible outcomes of Obama’s efforts:

KILLING IT SOFTLY

On a conference call with journalists, Goldman Sachs Chief Financial Officer David Viniar said he had not seen details of Obama’s plan, but that he generally appreciates government policies that stabilize the financial system.

Experts said that banks were unlikely to publicly disagree with Obama, but are sure to furiously lobby behind the scenes to water down any proposal that the president and legislators put forward.

Banks took similar steps when rulemakers and lawmakers sought to move more derivatives trading onto exchanges and into clearinghouses. Although trade groups initially said they supported efforts at reform, proposals now look likely to be watered down. Obama’s efforts to reduce risk taking could meet a similar fate.

Whether that is a good thing is debatable. Major banks including Lehman Brothers took large proprietary bets that resulted in big losses, and in Lehman’s case, forced it into bankruptcy. But many bank executives are quick to argue that if they can’t do this kind of trading, foreign banks and unregulated domestic entities will, which may not reduce systemic risk.

GRAY HAIR TRIUMPHS

A number of elder statesmen of the financial world, most notably former Federal Reserve chairman Paul Volcker, believe that Obama is right, and that large banks should be severely constrained from making bets with their own funds.

Obama seems keen to personally shepherd these changes through Congress, and given the populist outcry against Wall Street, he may have the political capital to do so.

If he is successful, the biggest banks will likely shrink further. Obama’s fee on bank’s liabilities, announced last week, may collect less money than originally planned.

Talented risk-taking traders will move to hedge funds and private equity firms, where their failures could have less of an impact on the broader market.

Trading volume on major exchanges and in many financial markets may drop, because smaller players will have less capital available to consistently trade. Shares of exchanges dropped on Thursday — NYSE Euronext <NYX.N> dropped 3.9 percent, while CME Group Inc <CME.O> fell 5.8 percent.

The biggest banks will likely become even less profitable, and more like staid, slow-growing utilities that pay high dividends to shareholders.

One question that remains is how far Obama will go in limiting banks from risk activities. Will a bank holding company be allowed to own a hedge fund, even if the regulated bank subsidiary cannot? Will commercial banks be barred from all investment banking activities? Will foreign banks that operate in the United States be constrained?

Also unclear is whether some institutions, such as Goldman Sachs, will be able to shed their bank charters to avoid restrictions on trading. Goldman Sachs CFO Viniar said on a conference call that the bank has no plans to get rid of its charter. Many investors believe it ought to, but regulators may balk at a move that would give them less oversight over a company whose health is critical to the financial system.

RULES CHANGE, BUT BANKS BACKSLIDE

Even if Obama successfully implements his risk limitations, banks may find ways around them. Banks, for example, could buy securities and claim they were doing so in anticipation of client demand, when in fact they intended to make bets on the securities and hold onto them themselves. Or bank holding companies could engage in risky activity that leaves their subsidiary banks worse off.

But if regulators are sufficiently vigilant, and limit risk-taking across many businesses in the financial sector, the brainpower that Wall Street devotes to finding loopholes may migrate to other sectors of the economy. From Obama’s standpoint, this may be the most positive scenario. (Reporting by Dan Wilchins) ((Reuters Messaging: dan.wilchins.reuters.com@reuters.net; +1 646 223 6320))

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