Saturday, January 23, 2010

Return of Glass-Steagall?

The Obama administration's proposals (as part of the comprehensive financial market reform Bill currently in the Congress) to impose stricter limits on the size and scope of trading activities of big banks to prevent excessive risk taking marks atleast a partial return to the era of Glass-Steagall and is a clear acknowledgment of the fact that the decision to repeal the Chinese wall between commercial and investment banking activities of financial institutions did contribute to the sub-prime crisis.

Last week the administration had announced plans to recover atleast a part of the costs incurred in the TARP bailout with something similar to a bank tax. This renewed vigor on fighting the big banks comes as President Obama said,

"My resolve to reform the system is only strengthened when I see a return to old practices at some of the very firms fighting reform; and when I see record profits at some of the very firms claiming that they cannot lend more to small business, cannot keep credit card rates low, and cannot refund taxpayers for the bailout. It is exactly this kind of irresponsibility that makes clear reform is necessary."

The Obama administration proposals include

1. Limit the Scope - No bank or financial institution that contains a bank (taking federally insured deposits) should own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

2. Limit the Size - Limit the consolidation of financial sector by placing broader limits on the excessive growth of the market share of liabilities at the largest financial firms, and to supplement existing caps on the market share of deposits. Since 1994, the share of insured deposits that can be held by any one bank has been capped at 10% and it is now proposed to expand that cap to include all liabilities, so as to limit the concentration of too much risk in any single bank.

Despite small concessions like payment of bonuses by deferred stock instead of cash, the remaining Wall Street majors have all announced record bonuses on the back of a resurgent equity markets and a market depleted of competition. Despite its less-than-stellar year (in fact, the first annual loss in its 74 year history in 2009), Morgan Stanley earmarked 62 cents of every dollar of revenue for compensation ($14.4 billion for salaries and bonuses), an astonishing figure, even by the gilded standards of Wall Street. Goldman, which made record profit of $13.4 billion for 2009 on revenue of $45.2 billion, has set aside $16.2 billion (or 35.8% of its revenues, lower than previous years) to reward its employees (or an average of $498,000 for its 32,500 employees). However, there remain doubts about later and backdoor payments that would boost the share of bonuses.

What has also raised popular outrage comes from the fact that most of the profits of these large firms have come from obscure and largely socially not-beneficial (some would say socially costly, given the excessive risk taking and inevitable bailouts) trading activities and not retail or commercial lending that directly contributes to economic growth. In fact, it is clear that these institutions cornered most of the benefits from the unprecedented quantitative easing measures, blanket debt guarantees and low interest rate policies of the Fed and the Treasury, which were originally meant to restore confidence in the financial markets and get banks to re-open their credit taps for cash-strapped businesses and individuals. However lending remains constrained with banks keeping their credit taps dry, under the excuse of counter-party risks, and are instead using the cheap money to play and drive the equity markets and their bottom-lines.

In this context, Simon Johnson (echoing Krishna Guha in the FT and the famous Pecora investigations into the causes of the Wall Street crash of 1929) has called for broad anti-trust investigations into some of the big firms. He sees "definite elements of oligopoly in wholesale markets, underwriting new issues, and mergers and acquisitions both in the United States and around the world", which has contributed to the very high profits in big banks over the past decade. He asks the question

"Is there evidence that our leading banks have used their pricing power or other aspects of their market muscle to keep out competition or otherwise distort behavior in very profitable arenas, like over-the-counter derivatives?"

Prof. Johnson also raises concerns about the dramatic increase in the share of assets in the largest six US banks that now stand around 60% of GDP, up from around 20% in the early 1990s, a level of concentration that increased during the crisis and bailout of the past two years. Among the regulatory steps proposed to address the problems generated by this concentration includes "raising capital requirements steeply, as well as a size cap on biggest banks to rein them in".

Apart from these, as Goldman Sachs CEO Lloyd Blankfein himself acknowledged in his recent Congressional testimony, there is an immediate need to bring the shadow banking system, consisting mainly of the unregulated over-the-counter (OTC) derivative products, under stricter supervision. Paul Krugman too has argued about the need to rein in the shadow banking system.

Update 1
Nice Economix post places the new plan, described the "Volcker Rule" by Obama himself, in historical perspective with respect to the Glass-Steagall Act.

Update 2
Viral Acharya and Matthew Richarson have this article commenting on Obama administration's bank reform - financial crisis responsibility fee and limit on the size and scope of trading activities - proposals. They write, "President Obama’s plans – a fee against systemic risk and scope restrictions - seem to be a step in the right direction from the standpoint of addressing systemic risk, if their implementation is taken to logical conclusions."

Update 3
Bank of England Governor Mervyn King argues "that big banks must separate their higher-risk trading and investment banking businesses from their core deposit-taking functions". He said, "After you ring-fence retail deposits, the statement that no one else gets bailed out becomes credible".

Unlike the US with its Glass-Steagall Act which was repealed in 1999, there have been no legla separation of investment banking functions for deposit taking bank holding companies.

Update 4
Simon Johnson has an incisive critique of the "Volcker Rule" on two grounds - the limit on scope rule can be overcome by banks that will immediately shed all their banking activities in the firm belief that they will be bailed out irrespective of anything; the limit on size rule applies only to future growth of bank and therefore ignores the problem of size among the incumbents.

He proposes some cap on the size of banks at some low level related to the real economy. He favors a cap on bank assets and liabilities as not more than a small percentage of Gross Domestic Product, and set that percentage so the banks go back to the size they were in the early 1990s, when the banking system worked fine and we didn’t have anything like our current levels of systemic risk.

Update 4
Daniel Gross has an excellent article that explores why the big five investment banks got too big, too greedy, too risky, and too powerful.

Update 5
Paul Volcker makes the case for financial market overhaul.

Update 6
Hank Paulson and Alan Blinder call for creation of a single systemic risk regulator (both prefer the Fed for this role because the responsibility for identifying and limiting potential problems is a natural complement to its role in monetary policy) and a resolution authority to impose an orderly liquidation on any failing financial institution so as to minimize its impact on the rest of the system.

Prof Blinder also advocates setting up a Consumer Financial Protection Agency (CFPA) to help unwary consumers from being duped into investments in risky financial products and restrictions between proprietary trading and trading, hedging, and market-making on behalf of clients, though he feels that the latter is very difficult to structure.

Update 7
Wall Street elders too call for more effective regulation of financial markets, with some going beyond the Volcker Rule and advocating banning any deposit taking commercial bank from indulging in any trading activity (not just proprietary), even for its clients - questioning whether trading operation should even exist under the same roof as a standard commercial bank.

Update 8 (22/5/2010)
The US Senate passes its version of the financial market regulation bill. See details of the comparison with the House version here and here.

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