Obama's new plan to rein in Wall Street has two parts. First it tries draw a bright legal line between commercial banks and investment banks by prohibiting commercial banks from trading on their own accounts to make money for their shareholders (otherwise known as proprietary trading). Second, it caps the percent of certain kinds of deposits a bank holds in an attempt to make banks smaller, and make their failures less calamitous.

What's wrong with this idea? A lot, according to my finance compatriot -- heretofore identified as Dr. Gonzo. Below is our Gchat conversation (lightly edited) on the subject.*

Dr. Gonzo:

Everyone is saying that Obama's plan will "break up the banks" and end "too big to fail." That's complete [manure].

Derek I'm listening. Go on.

Dr. Gonzo OK. So the plan, as far as I understand, would only apply to commercial deposit taking banks. Goldman Sachs, Morgan Stanley, etc. only became deposit taking banks because the Fed and Treasury forced them to. If Obama pushes this through they'll just dump their deposit business and do so with a smile. This would have a heavier impact on the Citi banks of the world, but even then this would have done ZERO to stop Lehman Brothers and Bear Sterns from failing. This would not have applied to them because they didn't take deposits. So in short, it's a solution to a problem that never happened.

Derek But really isn't that just an argument to go farther with regulations? I think Simon Johnson diagnosed the problem of Goldman just dumping its commercial deposit status in response to this regulation. So he's saying the same thing as you, but reaching the opposite conclusion: That this regulation doesn't do enough. That it has to affect more than commercial deposit taking banks.

Dr. Gonzo Then we're back to where we were last time. Simon Johnson is simply assuming that smaller is better, but there is nothing out there suggesting that's true. Common sense tells you that institutions need to be huge to place huge amounts of securities.

Derek But how do you account for the double-edged sword here -- that big banks have better access to capital and are more secure in that respect, but also that their bigness creates a moral hazard because they know that the government's bailout policy sets an implicit floor to their losses in the case of disaster?

Dr. Gonzo I don't buy that last part. How many times has this happened? A failure on this scale? Once. Every institution has good reason to manage its affairs properly. The CEO of Bear was completely wiped out. He was a billionaire, and now he is not. He did no go into this thinking that the US Gov will bail him out if things go poorly, because thinking like that will allow your competition to eat your lunch.

You might be able to make an argument to the contrary about the creditors of these large institutions, but no way this applies to the equity holders. AIG: equity wiped out. Citi: equity wiped out. Bear, Lehman: wiped out. The list goes on.

Derek So you really don't think too big to fail is a viable problem? Do you think other free marketers like Alan Greenspan who have essentially said 'to big to fail means too big to exist' are just talking sweet to Congress? Or trying to make up for past mistakes? Or are they just wrong on their own, honest merits?

Dr. Gonzo I can't say what other people think, but I can say that Greenspan certainly has an incentive to save face. I also think that a non-bank resolution plan would resolve most of these issues.

Something is only too big to fail because the methods of dealing with its failure are inadequate. Lehman is a giant. It does not belong in a federal bankruptcy court, but that's all we've got. If we had procedures that allowed the markets to continue to function around the failure that would be ideal.

Derek But a resolution plan for big firms is sort of like saying after a horrible fire 'OK, let's buy a bigger, better extinguisher for next time' right? Does it begin to address the problem of how the fire started?

Dr. Gonzo Well the fact that a firm fails shouldn't matter. In general it doesn't. Companies go bust all the time, and it has no real effect on the economy. Even giant companies go out of business with no material effect.

The problem with money centers going bust is they're the brain of the financial system. They hold securities for clients as custodians. They make markets. They place debt. When one of them fails, large swaths of the financial system stop working, and all of a sudden thousands of companies can't get financing for payroll, or paying rent, etc. That's what we should be trying to avoid.

That companies will fail is inevitable. There's no getting around it. Mistakes happen. The point is to minimize the impact of these mistakes.


*For a 360-degree perspective on the bank plan, you can also read Dan and Megan who have more positive takes on the bank plan.

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