Politics & Policy

The Wrong Financial Reforms

The stench of cheap populism pervades President Obama’s new banking proposals. He wants people to know he’s angry, very angry, at Wall Street. This is the political point of his proposals for a “Financial Crisis Responsibility Fee” and new limits on the trading activities of banks unveiled last week.

Obama wants to prohibit firms that hold federally insured deposits and enjoy access to emergency loans from the Federal Reserve from engaging in speculative trading for themselves, rather than for their clients. The rationale behind the plan is simple: Firms that enjoy a federal backstop should be prohibited from taking large risks with house money. We agree with the impulse.

Job One in post-bailout America is to clearly delineate which institutions have a federal backstop and which do not, and then to shrink the first group. The president’s proposal represents a move in that direction, although a flawed one that hasn’t been thoroughly thought through — not surprising, since it was released in a rush to provide a populist response to Scott Brown’s stunning victory in Massachusetts.

First, the prohibition on so-called proprietary trading could be easily evaded. Investment banks will argue that most of the trades they make benefit clients in one way or another. History teaches us that no matter how the regulations are drawn up, smart traders will figure out a way around them. The credit-default swaps that brought down insurance giant AIG were devised in part as a way to get around regulatory capital requirements.

Second, firms with explicit federal backstops played a relatively small role in the financial crisis. The major culprits — Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, AIG — were not traditional commercial banks that gambled with insured deposits. They were “too big to fail,” and, as such, they enjoyed the implicit backing of the government. Everyone knew that if Fannie and Freddie got into trouble, the government would bail them out. And the Fed-organized bailout of the hedge fund Long Term Capital Management in the late 1990s gave the big investment banks a reason to think that if they got into trouble, the Fed would ride to the rescue once again.

The biggest problem with the administration’s proposal is that it might distract policymakers from the problem it does not truly solve: How do you fence off the federally backed segment of the financial system when the whole thing appears to enjoy implicit government backing? Simply walling off commercial banks from the speculative side is not going to convince investors that the era of too-big-to-fail is over, though it might be a good first step in that direction.

A difficult debate lies ahead over what policymakers can and should do to restore market discipline to the world of high finance. It is not good enough for them to say, “No more bailouts.” Such promises were made after the bailout of Bear Stearns, and we now know that Bear Stearns was just the beginning. A workable solution will likely require concessions from some conservatives, who bridle at artificial limits on the size and scope of firms, and from liberals, who still haven’t come to terms with the role that the “affordable housing” agenda played in the crisis.

If Obama is interested in brokering a compromise that actually works, the populist shtick is not helping.

 

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