Posted on: Friday, January 22, 2010

Reining in the Banks

By Paul M. J. Suchecki
Tags: bank bailout, bank reform, economic news, ...
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Yesterday, President Obama urged adopting reforms that stem from a single premise: Banks should stop gambling in capital markets with federally insured money. He proposed regulations that would forbid any commercial bank from owning or investing in hedge funds or private equity firms trading in securities like stocks to boost its own profits. The new rule would also limit the size of financial institutions so that fewer would be “too big to fail” demanding another government bailout.

As the president put it, “We simply cannot accept a system in which hedge funds or private equity firms inside banks can place huge, risky bets that are subsidized by taxpayers… we cannot accept a system in which shareholders make money on these operations if the bank wins but taxpayers foot the bill if the bank loses.”

To understand the proposal, let’s take a look back at the early years of the twentieth century. Then banks were free to invest in securities. Rampant speculation, conflict of interest, and in some cases outright fraud let to a stock bubble, which ultimately burst into the Great Depression. To prevent its recurrence, Congress enacted the Glass Steagall Act in 1933 which erected a firewall between commercial and investment banking. Yet financial institutions got itchy, seeking to make more than a return on loans. The act was repealed in 1999 allowing a commercial bank like the Bank of America to buy a brokerage house like Merrill Lynch.

Today our economy is dealing with the hangover from a burst real estate investment bubble. According to the president, “This economic crisis began as a financial crisis, when banks and financial institutions took huge, reckless risks in pursuit of quick profits and massive bonuses.  When the dust settled, and this binge of irresponsibility was over, several of the world’s oldest and largest financial institutions had collapsed.”

The president named his proposal after Paul Volker an advocate of again separating commercial and investment banking. Mr. Volker is not some wild eyed reformer. He was the former Chairman of the Federal Reserve Bank under both Jimmy Carter and Ronald Reagan. Mr. Volker is credited with wringing massive inflation out of the economy which peaked at 13.5% in 1981. Last year inflation in the US was 2.7%.

Last week, in response to what he termed “obscene” bank bonuses, President Obama also urged adoption of a bank tax on the country’s largest financial institutions to recover all of the bank bailout funds supplied by taxpayers under the Toxic Asset Relief Program, TARP.

The president’s proposals require Congressional approval. Passage is far from certain with the loss of the Democratic Party’s filibuster proof majority in the Senate Tuesday due to first election of a Republican Senator from Massachusetts in 38 years. According to Iain Martin, writing in the Wall Street Journal, the president’s proposals are “as much about politics for Obama post-defeat in Massachusetts as it is about the banks… so he’s taking them on in an attempt to get back on the side of angry voters.”

Another strike against the president is the Supreme Court’s 5-4 decision yesterday that will allow corporations to spend freely on campaigns to defeat any politicians who don’t support corporate interests. After the court had heard the case, Republican Presidential standard bearer John McCain described the attitude that some of the justices showed to the role of special interest money in Congress as “extreme naïveté.”

Despite Goldman’s Sachs record $4.9 billion fourth quarter profit and comparable returns from other firms, financial stocks took a hit this week on Wall Street. Overall, the market took its biggest three day drop in a year. Expect the country’s major financial institutions to spend profligately in opposing Obama’s new potential curbs on bank profits.