Calls for more detail on Obama’s ‘too domestic’ reforms

8 February 2010 | By Vanessa Drucker

Some branded the approach as expedient political theatre, an exercise in bank-bashing; some would prefer a more holistic approach. Others question the potential impact on American bank competitiveness in the world arena. Yet although President Obama’s overtures have generated controversy, some common ground emerges.

These domestic proposals appear to neglect the global nature of the industry. Without integrated oversight and international participation, unintended consequences are doomed to pop up elsewhere (think of girdles that squeeze the tummy and bulge the thighs). Secondly, the blueprints are short on details and will need clarification. For instance, where is the line between market marking and proprietary trading? Or, precisely which assets will the ­liability cap encompass?

The levy, announced on January 14, would target risk-taking operations, but not customer savings. About 50 institutions with over $50 billion each in assets, including banks, thrifts (building societies) and insurance companies would be affected, with $1.5m collected for every $1 billion in assets.

“Resignation to some sort of tax is growing in the industry,” says Carol Beaumier, a consultant at New York-based Provitivi. Beaumier, who has worked as an examiner in the Office of the Comptroller of the Currency, adds: “Hitting the industry when it is down resonates badly with some.” (article continues below)

The formula for a rainy day fund may impose higher costs on banks at just the point in the cycle they can least afford them. Another school would prefer to create a fund available in the event of a disaster, instead of a tax linked to the bail-out.

Walter Mix, formerly commissioner of the California Department of Financial Institutions, sees no economic rationale for the levy, which he regards as politically driven, in Washington’s quest for scapegoats. He says the timing is dangerous in the context of a still shaky financial system and precarious economy.

”On one hand the administration seeks to impose a tax, while on the other it comes out with small business lending programmes”

Mix, now with LECG’s Los Angeles office, warns that banks will pass costs and shrink loans, reducing payments on deposits, or increasing interest rates or adding fees. He illustrates the illogic of countervailing proposals: “On one hand the administration seeks to impose a tax, while on the other hand it comes out with small business lending programmes.”

A week later, Obama proclaimed two more proposals, collectively dubbed the Volcker Rule, in homage to the former Federal Reserve chairman’s contribution. The first would limit the activities of commercial banks in proprietary trading, such as private equity and hedge funds, in operations unrelated to serving customers. The goal is to ring fence institutions that enjoy explicit government guarantees.

Jane D’Arista, of the Political Economy Research Institute at the University of Massachusetts, describes the initiative as a “step in the right direction, but too limited”. So far, the restriction aims at commercial banks, and misses insurance companies, among others. “Have we got everyone in the net?” she asks. Its reach should include all systemically important institutions.

The proprietary trading ban has been widely criticised as irrelevant, a measure that bypasses culprits responsible for the financial crisis.

 

D’Arista responds that, in fact, commercial banks were engaged in proprietary trading, through off balance sheet and special purpose vehicles. She would further address the deep-seated problems of inflation in the system, exposure and counterparty interconnections. Specific leverage ratios must be imposed across the board. After all, it is almost impossible to do proprietary trading on one’s own capital and without leverage.

It is too early to predict what reconfigurations might occur among today’s commercial banks. Speculation swirled on which organisations would be most affected and how far.

Rough estimates suggest that Goldman Sachs derives about 7% of its annual revenue from proprietary operations, with Morgan Stanley garnering about 3% and JP Morgan less than 1%.

As soon as President Obama announced the Volcker Rule, a flood of media comments focused on possible solutions for affected firms. Would Goldman Sachs or Morgan Stanley perhaps give back their commercial charters, hastily procured in September 2008 when they urgently needed access to the Fed window for government funding?

D’Arista points out that the Fed will soon be winding down guarantees and mortgage purchasing programmes. If they cannot sell to the Fed anyhow, why bother with commercial licences?

Finally, the Volcker Rule tackles the too-big-to-fail (TBTF) dilemma, exacerbated by last year’s bail-outs. To keep a lid on balance sheet size, Obama wants to broaden caps on banks’ liabilities, thereby expanding balance sheet limits. Since 1994, market share of banks’ insured deposits has been restricted to a 10% ceiling. A new regime would add non-insured deposits and various other assets to that list, but the question remains: which assets?

“Sure, we can do it, but what are we accomplishing?”

It is still vague. “Sure, we can do it, but what are we accomplishing?” Beaumier wonders. “What is the magic size? When you define systemic risk, size is not enough.” Many of the firms that failed or foundered, such as Lehman Brothers, Bear Stearns and AIG, were not commercial banks at all.

A cap on liabilities might have merit, D’Arista argues, if it were calculated in relation to GDP. “We don’t want a ­system that is individually or in aggregate too large, relative to economic output–as Iceland’s was.” But simply shrinking liabilities does not confront huge overseas subsidiaries and off balance sheet trans­actions.

Mix is even less enthusiastic about breaking up organisations. The former regulator would rather deal with TBTF problems on a case-by-case basis, with heightened and more integrated oversight. In reality, Wall Street has moved down to Washington DC. With Congress and the president intervening in financial supervision, the process becomes politicised.

Many say that professional regulators need a degree of independence, with express authority and funding. But in any case, the proposals are likely to morph into a different shape after Congress has recast the bills.