The Obama Administration’s Proposed Bank Plan; the “Volcker Rule”

Am l-o-v-i-n-g the headlines this morning.

“Asian Markets Drop after Wall Street Reacts to President Obama’s Bank Limits”

“FOREX – Dollar Falls on Obama Bank Plans, Yen Pares Gains”

“India Rupee Has Worst Week Since October on Obama Bank Plan”

Overreact much? For months now, think tanks and paid consultancies have identified several core reasons for the Fall 2008 economic meltdown. Ubiquitously crucial among which has been the ideas: that large organizations which threaten systemic failure with their own should be avoided, and that excessive risk-taking carries costs not immediately identifiable and therefore also should be limited. So yesterday the Obama Administration revealed - an albeit ambitious plan - to address both of those issues, and the market drops to the floor like a petulant toddler. Give me a break already; we have all known that change would come to market mechanisms. The banking industry is a vital and innovative engine for capital generation in this country and around the world; but this also makes it a key member of our shared community, and the hissy fit being thrown in response to being called to responsibility is a little much.

A look at what the bank plan in fact entails. The Administration, purportedly purposely, has left a wide berth for Congress to determine how to effectuate the plan. The core principles are quite clear, however: banking actors are made to choose between traditional banking activities or trading. The choice is forced as, under the plan, any bank that either takes consumer deposits that are federally insured, or otherwise has access to Federal Reserve funds, is prohibited from owning or investing or sponsoring a hedge fund or private equity firm. Banks will be prohibited from trading with their own money; proprietary trading. Administration officials yesterday did say, however, that banks would be able to use their capital to hedge a client’s trade. The intent of the bank plan is to prohibit any trading that is not in the pursuit of servicing a client. There is some ambiguity in the plan as to what “proprietary trading” entails (expect to see a variety of different definitions – and costs to the banking sector – pop up in the news over the next several days).

Separately, the bank plan also tweaks existing rules limiting how large any bank can grow. Currently, no bank can merge or acquire a second bank if the transaction produces an entity that has more than 10% of American deposits. Under the bank plan, deposits would only be one type of funding considered in reaching the 10% ceiling (Ie., short term funding acquired through the market is also proposed as a consideration).

It is expected foreign banks with significant American operations will be pulled into compliance.

Nothing is really ever as simple as all of that, but to boil the plan to the core, you basically have it. The market understands this – hence the hissy fit – because limiting activities is reasonably suspected to seriously constrict profits. (And while the safety afforded by a federal funding buttress is attractive, the real money in banking is in the trading.)

Smells like Glass-Steagall though, right? (Over simplified explanation: different market rules are enforced for different types of investment vehicles [collectively creating a number of different “buckets”], and buckets are not to be mixed.) “No” was the official buzzword from Administration officials throughout the day in response to that question. To be frank, I am too unfamiliar with the Glass-Steagall provisions to speculate, but I am certain there will (also) be plenty of punditry in the next several days that will make analogies and comparisons.

Early analysis has identified some risks to the proposal. The first, that the risky behavior prohibited will be eliminated from the banking industry, but will re-appear in non-financial institutions. Thus eliminating banking risk, but not eliminating the systemic risk. Another risk suggested is that banks, in an effort to make-up for the lost profit, will expand their lending guidelines and threaten the federal funding buttress with too many risky debtors. Relatedly, one of the bigger criticisms has been that the bank plan would not have prevented the Fall 2008 crisis: IBanks Bear Stearns and Lehman Brothers were not commercial banks.

The bank plan now goes to Congress for the House and Senate to pass their own draft legislation. The President's remarks are available here. The plan is in the news everywhere, including Bloomberg, the NYTimes, and the WSJ.

Photo credit: Klip at Wikimedia.

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