Megan already provided a great explanation of the Obama administration's new bank risk mitigation plan, but I wanted to offer a few additional observations. I agree with most of what she says. I don't really see too many incredibly negative consequences stemming from the plan, and if done properly some of it might really help. But there are a few things to think about here.
First, a quick review of the plan. I'll just quote Megan on both points, rather than reinvent the wheel:
First, banks that have access to the discount window will not be able to trade for their own account. That means no prop trading desk. No owning hedge funds or private equity funds. No investments of any kind to make profits for your shareholders. Financial institutions can make profits by servicing clients, or they can make profits by investing for their own book. But they can't do both.
The second proposal is to extend something like the caps that already prohibit banks from holding more than 10% of federally insured deposits, to other kinds of liabilities. I asked, but got no clarity, on what exactly this means. Are regulators going to swoop in whenever a diversified financial institution has too big a share of the total liabilities in all US debt markets? Or are they going to intervene when a bank becomes dangerous to one particular debt market, the way Lehman turned out to be in commercial paper?
Let's start with the first part. I'm far less excited about that aspect, because I'm wholly unconvinced that the mere existence of prop trading played a major part in the financial crisis.
Different From Lending, How?
First, Megan explains banks will no longer be allowed to invest for themselves by utilizing their capital if they want to continue to serve clients. I find this an odd concept, given that this is kind of exactly what banks are supposed to do.
Think of a run-of-the-mill regional bank. It doesn't do any "investment banking" or gamble with "fancy derivatives." It takes deposits through checking and savings accounts for customers. Then it provides all sorts of loans -- mortgages, auto loans, small business loans, etc. -- with those deposits, as prescribed by bank regulation. In short, the bank is using its customer's deposits to make profit by betting that the loans it makes (which could also be called "investments") will be profitable.
Now think about a prop desk. Here, the bank utilizes its capital base to invest in and trade all sorts of financial products: derivatives, mortgage-backed securities, credit card portfolios, you name it. In short, the bank is using its customer's and shareholder's capital to make profit by investing in various financial products.
What exactly is the difference between these two examples? Why can banks bet on loans but not derivatives or other financial products? Indeed, a bank could make much worse bets on loans than financial products -- just ask all those regional banks that have gone bankrupt in the past year due to bad mortgages.
I take the real motive in proposing this prop trading rule change to lower investment banking profits. It may do a little to reduce bank risk in the process, but that risk will just be shifted to non-bank hedge funds, private equity funds and other trading firms.