Don't Celebrate Obama's New Bank Breaking Effort Yet

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.

Why Not Make Prop Trading Safer?

Rather than eliminate bank prop trading altogether, why not just limit the risk involved? For example, if you required banks to hold more capital, utilize less leverage or provide more of a cushion for particularly risky trading activities, then wouldn't this mitigate risk from prop trading significantly? After all, that's what depositary insurance and reserve requirements do for regional banks' lending risk. What makes prop trading so awful that it needs to be essentially outlawed?

Liability Concentration Limits

The second part of Obama's plan is much more useful in avoiding systemic risk. It's also much more logistically challenging. But I take it to mean that banks will be forced to have only a certain amount of exposure to certain kinds of products. For example, if AIG only had, say, a mere 5% exposure to all real estate-related CDS, then it would have been in a lot better shape when the housing market crashed. So I'd really better term this proposal as "liability concentration limits." This is a direct way to control systemic risk. If the exposure to any given market is better spread across the financial industry, then no one firm can blow up the system if one industry or product deteriorates.

This, however, should absolutely not be limited to banks. For example, you could have a situation where a hedge fund bets massively on some industry. If it bets too much and loses, then that could still cause a catastrophic market event if it can't cover its obligations.

Remember, This Is Just A Proposal

Finally, I have serious doubts how much of this Obama administration proposal will actually make its way out of Congress. Far less controversial regulatory measures are already having trouble in the Senate. These suggestions would require several major Wall Street firms to spin off enormous chunks of their business. They would also likely result in their being forced to re-arrange their liabilities, which would require them to sell huge chunks of their portfolios.

Bear in mind that the bank lobby is extremely powerful. Goldman Sachs, one of the banks who will object to these regulatory measures as much as anyone, has a particularly strong influence in Washington. This proposal makes for a true test of just how much power lobbyists wield and how susceptible Washington is to their persuasion.

I would be quite surprised if the prop trading portion survived in any meaningful form. Goldman and others will almost certainly see to it that loopholes exist to allow them to continue doing business mostly as they please. The liability concentration limits might fare better, but as mentioned, they will also be much more cumbersome to actually structure and enforce.

So I wouldn't get too excited about today's news just yet. What we'll eventually end up with will likely be much different, but let's hope it isn't completely useless.