Obama bank plan is good policy, good politics
— John Kemp is a Reuters columnist. The views expressed are his own —
President Barack Obama’s proposed curbs on bank size and proprietary risk-taking will be criticised for being vague, hard to implement, and focusing on issues that were only part of the cause of the recent crisis.
But the president should ignore self-interested counsels of perfection from the industry that aim to preserve the status quo. The plan is good politics, and good policy.
On the political front, the plan is a belated attempt to reposition the administration and congressional Democrats. It aims to channel the popular revolt that washed away Democrats in New Jersey and Virginia last autumn and now in Massachusetts.
For much of the year, the administration and its allies have seemed obsessed by issues which are low on the list of voters’ concerns (healthcare, climate change) or reward special interests (bank bailouts) while appearing impotent to do anything about the rising tide of unemployment and punish those responsible for causing the crisis.
The president was radical where the electorate is cautious (healthcare and climate) but appeared to advocate the status quo where voters wanted change (banking, jobs and incomes). While each of these policies can be justified, the combination made the administration appear dangerously out of touch. The bank plan is an attempt to reconnect with the voters.
The bank plan is crucial to the administration’s course correction. It has been apparent for months that the rising tide of anti-incumbent sentiment would force the administration and congressional Democrats to change priorities or risk heavy defeat in November’s mid-term congressional elections.
Massachusetts, by giving Senate Republicans the 41st vote needed to filibuster controversial legislation, has made a shift inevitable as well as desirable. In the next few weeks, the administration will disappoint many of its supporters on the left by abandoning ambitious elements of its healthcare and climate programme, as well as card-check.
But the president cannot afford to seem weak or be “triangulating” towards the centre. The unabashed populism of the bank plan enables him to shift attention from healthcare, dominate the political conversation for a while, and provides useful cover for dropping other parts of his domestic agenda.
It puts the opposition Republicans in an exquisite dilemma. With their 41st vote, Senate Republicans now have the power to block the proposals. But if they do, Obama and his Democratic allies will campaign against them as friends of Wall Street and its unpopular bailouts. If Republicans agree to go along with the curbs, Obama wins a significant and popular victory.
Imperfect though it is, the plan is a sensible contribution to the policy debate. The “Volcker Rule” (requiring the separation of banking functions from hedge fund, private equity and proprietary trading activity unrelated to serving customers) in effect reformulates Glass-Steagall for the 21st century.
Glass-Steagall separated commercial banking activities from investment banking. But the real fault line in terms of conflict of interest and the moral hazard created by taxpayer guarantees has shifted. So the Volcker Rule seeks to separate the prudent provision of services on behalf of customers from higher-risk speculation on own account.
It is a form of the “narrow banking” proposals that have been endorsed by a number of commentators as well as policymakers such as Bank of England Governor Mervyn King. There is much to commend this approach. It has so far failed to gather much traction because of the lack of top-level political support. Obama’s endorsement should change that dynamic.
Reimposing market discipline after the bank bailouts and ending rampant moral hazard means some institutions must face the real threat of failure in future. But for some institutions to be allowed to fail, the government must guarantee the survival of others to provide a safe haven for retail deposits, basic payment functions, and essential commercial lending.
For there to be a periphery that can fail there must also be a core that is absolutely guaranteed, and clear separation between the two. The Volcker Rule attempts to establish this division (albeit in a rough and ready way).
Core banking institutions will face severe restrictions on their proprietary trading activities so the taxpayer guarantee does not cross-subsidise non-core trading and investment activities. In contrast, non-core institutions will be free to take proprietary risk, but cannot benefit from federal deposit insurance and will be forbidden from turning up at the Federal Reserve’s Discount Window and associated facilities.
If non-core institutions make poor choices they will fail and the losses will fall on shareholders rather than depositors or taxpayers. In the event of a systemic crisis they will also fail unless they keep sufficient liquidity on hand. Higher risk will be reflected in lower ratings and an increased cost of funding, ending the anomaly where institutions in the financial system that take the largest risk have the lowest funding costs.
Most of the objections to the Volcker Rule are easily disposed of:
(1) Some commentators will note hedge funds did not cause the crisis of 2007-2009 and did not suffer widespread failures; the focus on prop trading is therefore a mistake. But that is in fact an argument for separating out proprietary trading activities into separate institutions subject to rigorous market discipline and effective risk controls.
(2) Banks will argue proprietary trading creates substantial liquidity for both their customers and for the market as a whole. Pushing prop trading into separate institutions would cut the amount of liquidity they could offer their clients, and might cut the total amount of liquidity in the system as whole.
But shrinking the size of the financial sector might not in itself be a bad thing. Several commentators have noted the sector has grown much more rapidly in the last three decades than the real economy it is supposed to serve, and some of its activities have dubious social value.
Basic banking clearly has enormous social value. Hedge fund type speculation and private equity activities should also be allowed at investors own risk. The problem arises when one institution does both.
(3) Living wills and special resolution regimes are not a good substitute for the institutional separation of core banking and non-core proprietary risk-taking functions. These advanced directives are bedevilled by a credibility problem. The idea a universal bank can be one entity in life but broken up into separate entities in death stretches belief to breaking point.
If investors genuinely believed institutions would be broken up in death, and the cross-linkages between them severed, they would start assigning the different components different credit ratings and different funding costs in life, which would defeat the synergies involved in the universal banking model.
The biggest problem will be separately identifying proprietary trading on the banks’ own account from legitimate market-making activities on behalf of customers. Most banks have separate private equity departments. Some also have dedicated prop trading desks and internal hedge funds. But in many cases prop trading and hedge fund like activities have not been separated out.
It will prove hard to identify which securities are being held for strategic “speculation” and which are being held as part of a tactical, liquidity-producing trading book. In many instances the distinction may not make much sense, and is not how banks organise their operations. Difficulty in implementation is not a reason not to press ahead. Detailed regulations can be drafted later.
Enforcing a separation between proprietary trading and market making will require considerable intrusion from regulators (either in the form of rather blunt prohibitions or very intensive supervisory visits and demands for data).
Until now, supervisors have been reluctant to interfere this much in the internal workings of banks. But beefed up regulation is the inevitable condition for taxpayer support, and Obama’s endorsement will stiffen regulators’ resolve in the United States and elsewhere.