President Obama’s Excellent New Banking Proposal
President Obama has outlined a new banking proposal:
The White House wants commercial banks that take deposits from customers to be barred from investing on behalf of the bank itself—what’s known as proprietary trading—and said the administration will seek new limits on the size and concentration of financial institutions.
The limits on size and concentration are extensions of existing caps, and the meaning of this part of the proposal can only become clear with a lot more detail.
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. More precisely – since, as Megan McArdle’s shoe leather work has highlighted, many important details of even this part of the proposal remain to be determined or revealed – the concept the president has proposed is excellent.
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.
This is not the full extent of what’s needed, however. Though it’s impolitic to say this now, other parts of the financial system have become enormously over-regulated over the past couple of decades. Section 404 of Sarbanes-Oxley, as an example, could be easily renamed the “more accountants, fewer IPOs” act. Here is how I put this in a recent National Affairs article:
[T]he financial crisis has demonstrated obvious systemic problems of poor regulation and under-regulation of some aspects of the financial sector that must be addressed — though for at least a decade prior to the crisis, over-regulation, lawsuits, and aggressive government prosecution seriously damaged the competitiveness of other parts of America’s financial system. Since 1995, the U.S. share of total equity capital raised in the world’s top ten economies has declined from 41% to 28%. We do not want the systemic risks of under-regulation, but we should also be careful not to overcompensate for them.
Regulation to avoid systemic risk must therefore proceed from a clear understanding of its causes. In the recent crisis, the reason the government has been forced to prop up financial institutions isn’t that they are too big to fail, but rather that they are too interconnected to fail. For example, a series of complex and unregulated financial obligations meant that the failure of Lehman Brothers — a mid-size investment bank — threatened to crash the entire U.S. banking system.
As we work to adapt our regulatory structure to fit the 21st century, we should therefore adopt a modernized version of a New Deal-era ¬innovation: focus on creating walls that contain busts, rather than on applying brakes that hold back the entire system. Our reforms should establish “tiers” of financial activities of increasing risk, volatility, and complexity that are open to any investor — and somewhere within this ¬framework, almost any non-coercive transaction should be legally ¬permitted. The tiers should then be compartmentalized, however, so that a bust in a higher-risk tier doesn’t propagate to lower-risk tiers. And while the government should provide guarantees such as deposit insurance in the low-risk tiers, it should unsparingly permit failure in the higher-risk tiers. Such reform would provide the benefits of better capital ¬allocation, continued market ¬innovation, and stability. It would address some of the problems of cohesion by allowing more Americans to participate in our market system without being as exposed — or unwittingly exposed — to the brutal effects of market ¬collapses. It would also help get the government out of the banking business and preserve America’s position as the global leader in financial services without turning our financial sector into a time bomb.
As I argued in the post a year ago, limits on executive compensation in the regulated institutions are closely related to this structure:
[L]mits on executive pay, if they have any teeth as they are really implemented, are likely to have several knock-on effects. People who are able to make millions per year in a competitive market will tend to drift away from these firms (even though these restrictions only apply to senior executives, they would change the compensation culture for the firm as a whole), and form new asset management firms, M&A advisory boutiques and so on. Along with limits on comp, the government-sponsored entities will have restrictions on investment behavior imposed by the government – they will not be issuing a lot of credit default swaps. This will mean these large institutions will be unable to offer very high rates of return as compared to the firms that don’t take government money, but will offer safety.
Think of what we would then have: a tier of government-supported, low-risk / low-return big commercial banks that are run by competent, but not exceptional, bankers who are paid like senior civil servants; and another tier of high-risk / high-return financials that look like the “old Wall Street” that everybody says is dead. This is a world of walls, not brakes. When this tiering is in place, the government should be able to get out of the business of doing things like directly setting executive compensation.
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.
Amen, brother, and let’s also keep in mind that the transfer of wealth to which you refer has an important deleterious effect on the real economy – namely that far too many talented people are lured by the riches toward finance and away from occupations that could create wealth rather than simply reallocate it.
Wall Street abounds with various versions of no-lose bets with other people’s money. Banks betting with guaranteed deposits is one. Hedge funds take huge fees when they win and close their doors when they lose. IPOs are “underwritten” in such a way that the underwriter takes almost no risk but generates an enormous fee. M&A advisors have every incentive to make a deal happen regardless of whether it will be a win for the people whose capital is at stake. Public company CEOs nearly always come out ahead regardless of how the company’s owners make out. I’m sure others can add to the list.
— andrew · Jan 21, 09:57 PM · #
Scott Brown, Obama, and the Bankers
No matter what Obama said,
An always blue seat turned red,
To cover our shame,
We need someone to blame,
We need all the fat bankers dead.
— Randy · Jan 21, 10:58 PM · #
For people like me, who only know enough about banking to sound smart at parties, this kind of post is great. In a single space you flagged it, explained it, analyzed it, then put it into political and historical perspective. Value added, to say the least.
— Kristoffer V. Sargent · Jan 21, 11:27 PM · #
The Obama proposal isn’t bad, but I see a few problems.
First and foremost, it simply isn’t proprietary trading that has caused most financial firm failures. Bear’s trading department was doing great. What brought Bear and Merrill down was the inventory they had acquired as part of their origination and underwriting of MBS. The Obama proposal will not prevent this from happening again.
Second, what almost bought the financial system to a complete crash was the Reserve Fund failure. Money market funds are a low-profit, nickel and dime corner of the financial services world where nobody gets eight figure bonuses. So banker compensation has nothing to do with the real problems. Furthermore, the money market world is highly fragmented and highly competitive. Unfortunately, however, when one fails, they all fail. Limits on institutional size don’t have much importance when the fortunes of the many resulting institutions are all highly correlated.
— y81 · Jan 22, 12:05 AM · #
Great punchline to the piece. Republicans working with Democrats because it’s the smart and right thing to do… too funny.
— Erik Siegrist · Jan 22, 12:24 AM · #
I don’t know enough to make a good judgement, and I don’t know the full scale of the regulations, or the potential unintentional consequences, but because I do know we’ve gone so far way from the consequences of failure and market regulation, and that government interventions call for corrective interventions, which call for corrective interventions, which call for…I’m hesitant to use the word excellent. I think the effects of intervention are so far removed from the original causes, we’re lost in an endless series of symptomatic solutions to symptomatic problems, in a negative loop, spiraling downward — but, then, I haven’t had my evening medication.
— mike farmer · Jan 22, 12:58 AM · #
Jim,
I think you should be concerned about moral hazard here, with regards to government intervention into how individuals in the private markets receive compensation. Granted, the bailed-out banks created enough moral hazard for a decade, but two wrongs do not make a right.
I think we are seeing some of this moral hazard creep up in the debate on healthcare reform. Slashing doctor’s Medicare eimbursement rates is a major component of the legislation. The creation of the Medicare advisory board and “pay for performance” doctrine will also have lasting effects on how doctor’s are paid, and how much they are paid.
There many good reasons to be upset about employee compensation at financial firms. I don’t think having the federal government mandate certain forms of compensation is a good solution. Let Glass-Steagall come back, give it some time to work, and we will see the commercial banks become more stodgy and less risky. Inherently, big-bonus thrill seakers will not be attracted to the jobs at these firms. Let’s not give the fed more leverage than it already has, or needs.
— Matt C · Jan 22, 02:50 PM · #
Though it’s a step in the right direction, I don’t think this reform package solved the Too Big To Fail problem – and the implicit guarantee of government intervention in crisis that makes long-shot but common gambles attractive (Citigroup’s Chuck Prince and “dancing while the music is playing” thinking).
Remember, in the name of the crisis, we didn’t just save combined depository, insurance, and proprietary-trading banks. We saved GM and Chrysler and GMAC too – not because they used insured deposits to gamble, but just because they were “too big to fail”.
When the next crisis hits and the perception is that we are threatened with a panic, then what will prevent the government from feeling the overwhelming pressure to intervene with more bailouts to key players?
— Indy · Jan 22, 08:07 PM · #
So the markets tanking as soon as Obama announced his latest power grab (200+ points down)…
That doesn’t concern you?
All the folks with banking stocks in their 401Ks..do you think they’d be willing to see their nest eggs shrink even more just so obama can “get tough!” with those evil bankers?
By this “logic” – Obama saying we want ALL our money back, event hough the banks HAVE repaid the TARP funds….why doesn’t he slap a big tax on GM vehicles? They haven’t paid back all they got from the taxpayers (and probably never will). If his purpose is indeed to ‘get our money back”, then a steep tax on GM vehicles follows the same “logic” in taxing the banks.
— tomaig · Jan 22, 08:10 PM · #
I thought David Goldman’s (Spengler) take at First Things was interesting. – The traders’ point of view?
— Keid A · Jan 22, 08:31 PM · #
“So the markets tanking as soon as Obama announced his latest power grab (200+ points down)…
That doesn’t concern you?”
Uh, you do realize you’re talking about the same folks who led the global economy to the brink of implosion? I think it’s a self-evident truth that the folks running the markets are not exactly the people we should look to for guidence on economic or financial policy.
Mike
— MBunge · Jan 22, 08:56 PM · #
Excellent post. Please follow it up by making the wider argument that to be pro-market and pro-competition is NOT the same thing as always supporting Big Business and Wall Street, especially not in their efforts to make easy money through political connections, rent-seeking and cronyism. As the title of the book by Rajan and Zingales has it, the agenda for conservatives right now should be “Saving Capitalism from the Capitalists”.
If the Republicans were not bogged down in ideological bankruptcy they could have seized a great opportunity to attack the atrociously bad Geithner bailout packages on the basis of demanding much tougher accountability and regulation to save capitalism from Wall Street. This would have had the merit of being not only popular but also good economics.
But they blew it and now Obama has done a beautiful pivot to seize this agenda in the wake of the Massachussetts election. As you say, at this point the best thing for the Republicans would be go along with Obama. But the betting is extremely good that they will screw this one up royally. They’re going to come out opposing Obama’s “socialism”,but he’s going to whack the hell out of them for being stooges of Wall Street. Obama is going to recover a lot of the political ground he recently lost and the pathetic deluded Repubs are going to do much less well in November than they think.
— nb · Jan 22, 11:33 PM · #
As far as the markets go, they have been due for, and in my most humble opinion, looking for a reason to correct. That’s normal and even Wall Street can’t control the markets overbought and oversold conditions forever. But that’s a side issue. If Obama launches an intelligent, tactically well planned, aggressive deconstruction of the banking monsters that have hobbled our country; if he can get all 59 Democrats on board…then every nonparticipating Republican will stick out like a sore thumb. I believe the voters will have no sympathy to elected officials who are open apologists for the likes of Goldman Sachs.
— Ingmar helling · Jan 23, 05:17 AM · #
The ideas are great. But how long will it be before regulation gets killed under the guise of ‘interfering with the free market’ or ‘smaller govt.?’ Already we have people crying that a tax on banks will stifle investment.
What we need to do is re-invent popular economics. We have been fed so long on fundamentalism; the idea that an unregulated ‘free market’ always works. The fact is, it doesn’t. But the myth still has ALOT of traction in popular imagination. Unless and until we put that argument to sleep, the lobbyists will win and responsible regulation will get nowhere.
— bob puharic · Jan 28, 03:11 PM · #