President Obama has outlined a new banking proposal:
The White House wants commercial banks that take deposits from customers to be barred from investing on behalf of the bank itself — what’s known as proprietary trading — and said the administration will seek new limits on the size and concentration of financial institutions.
The limits on size and concentration are extensions of existing caps, and the meaning of this part of the proposal can only become clear with a lot more detail.
The first, and core, concept of the proposal is the re-segregation of commercial banking from proprietary trading (or roughly what used to be called commercial banking from investment banking). This is an excellent proposal. More precisely – since, as Megan McArdle’s shoe-leather work has highlighted, many important details of even this part of the proposal remain to be determined or revealed — the concept the president has proposed is excellent.
I have been arguing for more than a year that this was the direction financial regulation needed to go, and that the logic of the situation would drive us here. The reason why is straightforward.
Finance professionals, like members of all occupational categories, attempt to build barriers that maintain their own income. One of the techniques used is to shroud what are often pretty basic ideas in pseudo-technical jargon. The reason that it is dysfunctional to have an insured banking system that is free to engage in speculative investing is simple and fundamental. We (i.e., the government, which is to say, ultimately, the taxpayers) provide a guarantee to depositors that when they put their savings in a regulated bank, then the money will be there even if the bank fails, because we believe that the chaos and uncertainty of a banking system operating without this guarantee is too unstable to maintain political viability. But if you let the operators of these banks take the deposits and, in effect, put them on a long-shot bet at the horse track, and then pay themselves a billion dollars in bonuses if the horse comes in, but turn to taxpayers to pay off depositors if the horse doesn’t, guess what is going to happen? Exactly what we saw in 2008 happens.
If you want to have a safe, secure banking system for small depositors, but don’t want to make risky investing illegal (which would be very damaging to the economy), the obvious solution is to not allow any one company to both take guaranteed deposits and also make speculative investments. This was the solution developed and implemented in the New Deal. We need a modernized version of this basic construct, and as far as I can see, this is what President Obama has proposed.
This is not the full extent of what’s needed, however. Though it’s impolitic to say this now, other parts of the financial system have become enormously over-regulated over the past couple of decades. Section 404 of Sarbanes-Oxley, as an example, could be easily renamed the “more accountants, fewer IPOs” act. Here is how I put this in a recent National Affairs article:
The financial crisis has demonstrated obvious systemic problems of poor regulation and under-regulation of some aspects of the financial sector that must be addressed — though for at least a decade prior to the crisis, over-regulation, lawsuits, and aggressive government prosecution seriously damaged the competitiveness of other parts of America’s financial system. Since 1995, the U.S. share of total equity capital raised in the world’s top ten economies has declined from 41% to 28%. We do not want the systemic risks of under-regulation, but we should also be careful not to overcompensate for them.
Regulation to avoid systemic risk must therefore proceed from a clear understanding of its causes. In the recent crisis, the reason the government has been forced to prop up financial institutions isn’t that they are too big to fail, but rather that they are too interconnected to fail. For example, a series of complex and unregulated financial obligations meant that the failure of Lehman Brothers — a mid-size investment bank — threatened to crash the entire U.S. banking system.
As we work to adapt our regulatory structure to fit the 21st century, we should therefore adopt a modernized version of a New Deal-era innovation: focus on creating walls that contain busts, rather than on applying brakes that hold back the entire system. Our reforms should establish “tiers” of financial activities of increasing risk, volatility, and complexity that are open to any investor — and somewhere within this framework, almost any non-coercive transaction should be legally permitted. The tiers should then be compartmentalized, however, so that a bust in a higher-risk tier doesn’t propagate to lower-risk tiers. And while the government should provide guarantees such as deposit insurance in the low-risk tiers, it should unsparingly permit failure in the higher-risk tiers. Such reform would provide the benefits of better capital allocation, continued market innovation, and stability. It would address some of the problems of cohesion by allowing more Americans to participate in our market system without being as exposed — or unwittingly exposed — to the brutal effects of market collapses. It would also help get the government out of the banking business and preserve America’s position as the global leader in financial services without turning our financial sector into a time bomb.
As I argued in the post a year ago, limits on executive compensation in the regulated institutions are closely related to this structure:
Limits on executive pay, if they have any teeth as they are really implemented, are likely to have several knock-on effects. People who are able to make millions per year in a competitive market will tend to drift away from these firms (even though these restrictions only apply to senior executives, they would change the compensation culture for the firm as a whole), and form new asset management firms, M&A advisory boutiques and so on. Along with limits on comp, the government-sponsored entities will have restrictions on investment behavior imposed by the government — they will not be issuing a lot of credit default swaps. This will mean these large institutions will be unable to offer very high rates of return as compared to the firms that don’t take government money, but will offer safety.
Think of what we would then have: a tier of government-supported, low-risk / low-return big commercial banks that are run by competent, but not exceptional, bankers who are paid like senior civil servants; and another tier of high-risk / high-return financials that look like the “old Wall Street” that everybody says is dead. This is a world of walls, not brakes. When this tiering is in place, the government should be able to get out of the business of doing things like directly setting executive compensation.
The political aspects of such reform are compelling. People are disgusted at recent bank bonuses. I’m a right-of-center libertarian businessman, and I’m disgusted by them. Make no mistake, many banking executives right now are benefiting from taxpayer subsidies. Even if they pay back the TARP money, the government has demonstrated that it will intervene to protect large banks. This can’t be paid back. And this implicit, but very real, guarantee represents an enormous transfer of economic value from taxpayers to any bank executives and investors who are willing to take advantage of it. Unsurprisingly, pretty much all of them are.
The “populist” observation that the fact of a bunch of well-connected guys each pulling down $10 million per year while suckling on the government teat constitutes almost certain evidence of self-dealing is accurate, and all the fancy finance talk in the world can’t get around it. President Obama has a clear political incentive to pursue this proposal. I assume Republicans will see that they have a clear political incentive to go along, rather than standing up for such a situation. Hopefully, this will create the political dynamic that will allow real, positive reform.