Obama (and Volcker) Speak, And The Markets Listen

President Obama made a brief but powerful proposal for additional bank regulation today, bringing the ideas of former Fed chairman Paul Volcker to the fore, and triggering sharp reaction in financial stocks. Large institutions would really have to pull in their horns, and smaller banks would be able to compete for retail business more effectively. The proposals are so sketchy, though, that it's hard to see how they could be implemented without pulling a lot of companies apart -- but maybe that's the point.

The president spoke around noon, and financial stocks reacted sharply, with the investment banks (such as Goldman Sachs and Morgan Stanley, which stand to lose the most from these sorts of new constraints) selling off five percent and more, and the regional banks trading up. If I've linked it right, going here will show you a graph of today's trading.

President Obama's actual comment was short, and laid out just two ideas. One, that banks and their affiliated companies would not be able to engage in proprietary trading (that is, trading for their own account rather than customers), or to own, invest in, or sponsor hedge funds or private equity funds. The goal here is to reduce or eliminate banks taking inappropriate risks with depositors' government-guaranteed funds.

The ideas are the sort that have been advanced by chairman Volcker. Candidate Obama signed Volcker as an adviser early on, and so far he has been kept in the back row, but it's great to see his experience and judgment given such a prominent role.

Two, that steps would be taken to limit consolidation and concentration in the nation's banks. This step would increase competition and possibly reduce the cost of bank services.

The proposals are quite sweeping, but at the same time were so brief that it's hard to think through how they might be possible to implement. But here are a few comments from people who know more than I do:

David Viniar, Goldman's chief financial officer, called the proposals "impractical" and said they harken back to the Depression-area Glass-Steagall Act. That law, repealed in 1999, required the separation of institutions involved in capital markets from those engaged primarily in traditional consumer banking.

"You have global institutions around the world who are set up in a certain way and to put rules in place that roll back the financial system by 10 years I think is going to be a very, very hard thing to do," he said in a conference call with reporters

Press reports suggest that the Obama Administration wants to bring back some form of Glass Steagall the Act that separated banking functions among multiple financial industries. If this were done it is likely to have three impacts on three different constituencies: Stockholders could get a bonanza. The nation's financial system would be crippled. The global financial system would be unaffected.

If the industry goes to the ultimate end and starts separating consumer finance from the rest of the financial businesses, a number of very attractive companies will be split off from the big banks. Who really doesn't want to own Merrill Lynch or the capital markets division of JPMorgan Chase ... without the drag of credit cards and mortgages?

I love this [that is, the President's proposed limits on the excessive growth of the market share of liabilities at the largest financial firms]. It's bank liabilities which cause systemic risk: that's why it's bank liabilities which are subject to the bank tax. And as too-big-to-fail banks increasingly rely on wholesale liabilities rather than a more stable deposit base, it's important to place some kind of restrictions on the degree to which they can do so. In his press conference, Obama said that banks should not be allowed to stray too far from their mission of serving depositors: he's moving, here, towards a vision of narrow (or at least narrower) banking.

In private, however, ... a very different message is being sent about how much smaller the Obama administration wants America's biggest banks to be. The answer: no smaller than they are now - even after the wave of panic-induced M&A at the height of the financial crisis.

...[T]he proposed Volcker rule will try to cut back on some of that borrowing and gambling, but it probably wouldn't have had any effect on their idiotic actions in mortgage-backed securities and collateralized debt obligations. Banks will always find a way to lose money: not all banks fail, but there are always bank failures. The important thing is that when banks fail, there aren't massively destabilizing systemic consequences. And the only way to ensure that is to make the biggest banks smaller. It's sad that the Obama administration seems to have flubbed this final chance to get that done.

Besides, these sorts of measures don't get to the heart of the crisis: lax regulation over the credit quality of home mortgages, and holding interest rates at ridiculously low levels that distort the risks and rewards of banking and investment.

But as I wrote earlier this week, I think a fee on banks' uninsured liabilities would be very effective in controlling excessive risks from banks grown too large.

Please see this related post:
A Bailout Tax On Banks? Absolutely