Obama and The Banks: Part 2

Well Obama came out swinging. Not quite hard enough for my taste – I remain a hard liner when it comes to the banks – but at least there was a hint of anger and a suggestion of a willingness to fight. That is a pleasant change from the insipid and muddled approach we had to suffer through on health care. The immediate downward plunge in bank stock prices was an accurate reaction from the markets. It could be, I stress that word ‘could’, that the days of bank rent seeking are over.

Let’s hope anyway.

The really good news, and I must admit it was both a great boost and surprise, was that Paul Volcker seems suddenly to have gone from forgotten periphery figure to central actor. Almost overnight the so-called ‘Volcker Rule’ has become a major component of the administration’s attempt to re-regulate the banking industry. Since I have always had a soft spot for Paul Volcker, I have to voice my pleasure at this turn of events.

The basic themes of the new proposal are to place limits on bank size and to separate investment banking from commercial banking in the manner of the old, and much lamented, Glass-Steagall Act. The banks took decades of lobbying to get rid of Glass-Steagall and only one decade to abuse their new powers sufficiently to warrant its return. If that isn’t a lesson for economists I don’t know what is.

For those of you whose eyes glaze over whenever bank reform is mentioned please pay attention: in my opinion – and I am by no means alone – getting the banking system back onto a sound footing is the most important single structural domestic issue facing America today. Balancing the Federal budget is a distant second. Fixing health care is part of the budget balancing process and so is subsumed in that second priority. You will notice that I was careful to say ‘structural’ issue because I view getting the employment situation as a cyclical or short term issue. The difference, of course, is that structural issues are those that need permanent or long term attention.

The banking system is broken. It is being exploited by ruthless individuals at the big banks to pad their own wealth. It has veered into unsafe territory because those individuals are willing to take vast risks with other people’s money safe in the knowledge that if they screw up they will be bailed out by the taxpayers. This sounds too simple to be true, but it is the essence of our problem. The big banks have gone on an orgy of risk taking that they scarcely understood and failed to manage. Traditional banking skills like relationship building and tending were thrown overboard and new skills introduced: ‘deal making’ became the norm. So perverse did the banking culture become that deal making was seen as a new form of relationship building. Goldman Sachs exploited its relationships to broker deals and saw itself as the epitome of a relationship bank.

But relationships in banking are not asymmetrical in the way Goldman sees them: they are mutual. Both sides should benefit. I read and hear far too many complaints from Goldman customers that the information they hand over on the course of one deal is then exploited relentlessly by Goldman for its own profit in unconnected deals. It might not be against the law, but it is corrosive to long term mutual benefits if the bank can endlessly take information and use it for its own book without compensating the customer in some way.

As I mentioned yesterday one reason I advocate breaking up the banks – rather than simply restricting their size – is to induce competition. The relationship exploitation I just referred to is one form of anti-social behavior that extra competition would control or eliminate. Right now Goldman and the others can run roughshod over their own customers because those customers have little choice about where to go to get their banking needs met.

I have said it hear repeatedly: the benefits of capitalism – which are abundant – are only ever delivered in real terms when competition exists. The heart of capitalism is competition, not profit making. The allure of profits generates competition. Competition drives innovation. Innovation drives cost cutting and lower prices. The end result is that customers end up paying less for better products. they are wealthier as a result. Along the way capitalists can make short term profits but not long term profits. The only way, in theory, that a capitalist can make long term profits is to innovate endlessly.

Defenders of banking argue that we have seen enormous innovation from the big banks. That is a shallow and failed argument. Innovation is not the creation of even more obscure legalese and fine print. Nor is it the creation of products that only exist to pad out bonus pools. The banking system is supposed to allocate capital effectively through the economy, and to provide a low cost and sound payment system so we can save and get cash reliably when we need to. As Volcker has said, the last big innovation in banking was the ATM machine. The plethora of murky and dubious securitized ‘products’ don’t count: they are simply variations on an old theme.

But, back to Obama.

The proposals have the right thrust. Capping bank size at 10% of the nation’s deposit base is a good start. There are a host of details yet to work out, and I imagine that the armies of lawyers Wall Street employ are already devising sinister schemes to dodge any new rules. Similarly putting a stop to ‘proprietary’ trading will be enormously difficult in practical terms since identifying such trading and separating it from trading undertaken on behalf of a customer is sometimes very difficult. [Proprietary trading is that done by a bank for its own profit rather than being done to satisfy a client need]. Besides, there is little evidence that proprietary trading contributed excessively to the banking melt down. The really big errors were made in securitization and the failure to understand elementary risks of things like sub-prime mortgages and commercial real estate loans. A final objection to a ban on proprietary trading is that banks use such positions to hedge their risks: do regulators really want to expose banks to excessive risk?

So the details will determine the success of the proposals. My approach as you know is much more blunt for exactly the reason that banks are very good at cheating and getting around rules. I know. I helped devise such schemes. Since I believe that creative bankers, lawyers, and accountants will always find ways to cheat – the financial incentive is too powerful for them not to try – then we need to accept that fact and act accordingly. We need to assume cheating and therefore insulate ourselves against the result.

The only way to do that is to limit our exposure to the banks.

To do this we need to force banks to play with their own money and not ours. One way to do this is to increase capital requirements way beyond where they are now. Entering the last crisis most of our banks met or exceeded current capital requirements so we know that such rules are not a solution by themselves. They do, however, limit the taxpayer involvement in a crisis. So start there.

Next we need to limit our insurance exposure. Some bank activities should be made clearly uninsured. Proprietary trading is a good example. We can do this by hiving off that form of banking into uninsured private banks – like the old time investment banks – and thus restricting our insurance to commercial or main street banks. We can limit the size of banks so that each bank failure does less damage. And we can raise the fees we charge banks for the insurance, so as to price properly for the privilege of using our insurance backstop. Naturally banks will raise prices to customers for any increase in insurance costs, but that will have the positive effect of dampening demand for bank services and slowing the industry down, which is not a bad thing at all.

The Obama proposals, based as they are on the Volcker recommendations, aim along these lines. As such they are a major step forward.

Are they enough? No. But they are a much better set of ides than the pablum being put forward by the Treasury Department or the Federal Reserve Board.

Which brings me to the politics of the proposals.

It is quite apparent that a shift in power within Obama’s advisory circles led to yesterday’s announcements. The ludicrous capitulation of the Democrats in Massachusetts obviously contributed to the hasty timing, but the infighting over bank reform had been going on much longer. Obama had originally asked for reform proposals on his desk by year end 2009. That didn’t happen and so he switched to plan ‘B’. I have already said that the winner of the switch is undeniably Volcker, and to a lesser degree Goolsbee at the NEC, the big losers are Geithner and Bernanke. Geithner because he fumbled getting a reform package organized last year, and Bernanke because he represents so much of the status quo.

Indeed the first victim of Obama’s shift in focus could well be Bernanke whose confirmation is now in the balance. As the Democrats try to reframe the political debate in reaction to the loss on Massachusetts and obvious and vulnerable target will be the banking industry and all those who apologize for its anti-social antics. Bernanke is front and foremost in that line. His recent defense of the Fed was all about limited action and new obscure rules to empower the Fed. A quiescent Congress might well have gone along with him. A chastened and newly populist Congress might not.

Geithner too is in trouble. He has openly opposed the Volcker style fix for banking, and has argued for incremental and more bureaucratic approaches. While he stood on the podium yesterday as the president made his statement, he was unusually pushed to the back behind the towering figure of Volcker.

So a shift for the better has taken place. There is an opportunity to get banking back in a box where it cannot do the damage it did. I was pleasantly surprised by the content of Obama’s announcement. I was particularly pleased by the evident influence Volcker has had. Now comes the tricky bit: getting the details worked out. But this time at least we are working from a strong position. The odds are much better that we will get something meaningful.

That’s change progress we can believe in.