A new sheriff in town

Can fresh regulations bring order to a lawless financial system? Huw Thomas investigates.

“When banks benefit from the safety net that taxpayers provide it is not appropriate for them to use that cheap money to trade for profit”
-Barack Obama

The Glass-Steagall act of 1933 attempted to impose order on an industry that was widely perceived as dangerously lawless. Like some distant frontier town during the Gold Rush, Wall Street in the 1920s pursued an 'anything goes' ethos where the only end was striking it big. But while the pioneers of the Old West often gambled all they had in the pursuit of big rewards, their financial counterparts instead put the livelihoods of millions of ordinary Americans at risk. As a direct result of bank failures America experienced a period of economic hardship that has yet to be surpassed. The banking crisis of recent years has dredged up uncomfortable memories of these earlier failings and given rise to the idea that a financial system  which has become a little too Wild West is in desperate need of much stronger regulation.

Cast in the unlikely role of Sheriff is 82-year old former Federal Reserve Chairman Paul Volcker, whose plan to clean up the banking industry has been seized on by President Obama. At its heart, the proposal will limit the activities of banks and prevent them from becoming too 'big to fail', protecting American taxpayers from the need to prop up failing institutions that threaten to bring down the entire financial system.

In the eyes of many, it was the repeal of Glass-Steagall in 1999 that set the scene for the economy's recent travails. Allowing the merger of Citicorp and Traveler's Group to create a financial supermarket involved in myriad types of business, the repeal opened the door for banks to get involved in ever more sophisticated investment activities. This was undoubtedly great news for banks and their shareholders, at least in the short-term, as profits shot through the roof. However, involvement with ever more arcane financial products such as credit default swaps and mortgage-backed securities exposed institutions to massively increased levels of risk. When the house of cards started to collapse in 2007, it was not only investors who stood to lose, but also bank customers who did nothing more than regular vanilla banking.

A few years and billions of dollars in bailouts later, there is an understandable groundswell of public opinion towards banks being put under stricter controls to ensure that such a colossal failure can never happen again. The key spoke of the plan proposed by Volcker concerns preventing banks from becoming 'too big to fail' by limiting the ways in which they can expose regular bank customers to the risks inherent in the global financial markets. "That proposal, if enacted, would restrict commercial banking organizations from certain proprietary and more speculative activities," Volcker said in a statement to the Senate Committee on Banking, Housing and Urban Affairs in February 2010. "In itself, that would be a significant measure to reduce risk. However, the first point I want to emphasize is that the proposed restrictions should be understood as a part of the broader effort for structural reform. It is particularly designed to help deal with the problem of 'too big to fail' and the related moral hazard that looms as an aftermath of the emergency rescues of financial institutions, bank and non-bank, in the midst of crises."

So far, so populist. Current public anger at bankers is such that a proposal to tar and feather the entire industry would probably draw a reasonable amount of support. However, wiser heads have also spoken up in favor of Volcker's idea. Some of Wall Street's elder statesmen, people like billionaire investor George Soros, former Citigroup Chairman John Reed and former Treasury Secretary Nicholas Brady, have echoed the call for more restrictions on banking activities. "If you are a commercial bank," Brady said, "and you wish the government to guarantee your deposits and bail you out if necessary, then you can't be involved in speculative activity." Reed has also voiced his support for a return to more exacting standards: "I can be convinced that we should move back in the direction of Glass-Steagall," he is on record as saying.

But consensus remains some way off. Many in the business are concerned that excessive restrictions would have a major impact on profits. "The claim that Volcker makes is that it will only affect a limited number of global banks," says TowerGroup analyst Rod Nelsestuen. "The challenge is that those banks do big business in this area. The question is how much of their bottom line will be affected? I've seen estimates from anywhere from five to 15 percent of the bottom line of these global banks will be affected by the inability to trade for their own book and do their own proprietary investments." The market seems similarly unenthusiastic, bank shares tumbling around the world when the administration's intent was announced in January.

Such negative potential impacts on revenues are understandably hard to swallow for the industry, but were they to provide a more secure system that could never again plunge into the kind of chaos we have recently witnessed, then surely that would be a sacrifice worth making?  Unfortunately, there is plenty of concern that Volcker's prescription isn't the best answer to the economy's ills.

"The Volcker rule and similar misguided legislation to reestablish the Glass-Steagall Act assume that a bank should be essentially a utility limited to taking in deposits and making certain types of safe loans," says The Heritage Foundation's David John. "They reason that if banks are protected from risky activities, other types of financial services firms can be allowed to fail without causing problems to the overall financial system. However, these proposals completely miss the point that as far back as the 1998 failure of the hedge fund Long-Term Capital Management, systemic risk to the financial system is less likely to come from banks than from non-banks."

John argues that none of the financial firms that failed during the crisis did so because of their size or because banks engaged in proprietary trading. The failures of Bear Stearns and Lehman Brothers, two of the main harbingers of the crisis, were significant because of the interconnected nature of the modern financial system. Neither was particularly big and crucially, neither was actually a bank. "An additional level of instability was caused by many major financial institutions having relatively small amounts of capital available to absorb losses," he continues. "They also had limited amounts of liquid assets to cover losses and repay the short-term loans that financed many of their activities. Neither the Volcker rule nor restoring the Glass-Steagall Act would do anything to reduce that interconnectedness or to increase liquidity."

Others are a little less damning in their criticism of the plan, instead citing concerns about a lack of detail in the proposal. "They haven't defined these rules closely enough," says Rod Nelsestuen. "Some of the activities that these banks would be doing along these lines would be called risk management, diversification, they would be called offsetting other types of risk in different business lines. The idea that you can't trade for your own book is an oversimplification. Diversification is in some cases a way of managing risk, so some institutions could use it as a risk management tool. Proponents are saying that the new rule doesn't mean banks will be limited to the point where they can't manage risk, but then what exactly do they mean? That's unclear."

There are also concerns over exactly what is meant by the term 'too big to fail'. Nelsestuen describes a trading company that was located in the Twin Towers of the World Trade Center when it was levelled on 9/11. Though this company had only around 700 employees, it did a huge amount of business in government bond trading and its loss was keenly felt by the market. "It's interesting to try and define too big to fail as asset size versus what their function is in the banking world," Nelsestuen continues.

Were the rule to be implemented, just enforcing it would be a major headache. Differentiating between proprietary trading and that done for clients will be incredibly difficult for regulators. In fact the way that regulation is approached in the US might prove to be one of the most significant hurdles for any new regulatory regime. Compared to the system in place in the UK for example, which is largely principle-based, the US tends towards a more rule-based approach. This is especially true at the moment, when attention is focused on very specific grievances. The problem here is that the more specific the rule is, the bigger the opportunity is to engineer around them. "Public outcry sometimes gets very specific when in reality what we need is to step back and think about what are the basic principles under which the financial industry should operate, how do we articulate them and how do we hold institution accountable for following them. That would be a better way but I don't think we'll be getting there in the short term," Nelsestuen agrees.

Given the current climate, it is perhaps understandable that the Volcker rule is not seen as going far enough by some who would prefer a full reinstatement of Glass-Steagall. That however, is highly unlikely even for a government enthusiastically riding a wave of anti-banker populism. "It's just not realistic in today's interwoven economy," says Nelseusten. "The financial system has to be able to operate within the economy and the economic structure of its service territory. To simply say that we're going to go back and limit a type of activity without looking at the impact in the economy in general or whether it even fits the business model of the global economy today is very short-sighted."

For all the rhetoric, it seems unlikely that we are going to see any drastic changes in the regulatory system any time soon. Given the glacial pace at which legislation passes through government and the deep-rooted differences at the heart of the debate, anything that can be agreed on by everybody is likely to be far more nuanced in its language than Volcker's initial suggestion. That is going to take time and a great deal of effort. The hope must be that all parties can work together to craft something that fulfils the need for greater control while not unduly hampering the financial industry's ability to profit and power the US economy. As a nation, America's success has been built on a careful blend of pioneering risk-taking and the rule of law. If the financial industry is to emerge from its 21st century troubles, it needs to heed the lessons of the past.

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Fighting talk

President Obama signals his intent to rein in the financial system

This economic crisis began as a financial crisis, when banks and financial institutions took huge, reckless risks in pursuit of quick profits and massive bonuses. When the dust settled, and this binge of irresponsibility was over, several of the world's oldest and largest financial institutions had collapsed, or were on the verge of doing so. Markets plummeted, credit dried up, and jobs were vanishing by the hundreds of thousands each month. We were on the precipice of a second Great Depression.

To avoid this calamity, the American people – who were already struggling in their own right – were forced to rescue financial firms facing crises largely of their own creation. And that rescue, undertaken by the previous administration, was deeply offensive but it was a necessary thing to do, and it succeeded in stabilizing the financial system and helping to avert that depression.

we should no longer allow banks to stray too far from their central mission of serving their customers. In recent years, too many financial firms have put taxpayer money at risk by operating hedge funds and private equity funds and making riskier investments to reap a quick reward. And these firms have taken these risks while benefiting from special financial privileges that are reserved only for banks.

Our government provides deposit insurance and other safeguards and guarantees to firms that operate banks. We do so because a stable and reliable banking system promotes sustained growth, and because we learned how dangerous the failure of that system can be during the Great Depression.

But these privileges were not created to bestow banks operating hedge funds or private equity funds with an unfair advantage. When banks benefit from the safety net that taxpayers provide – which includes lower-cost capital – it is not appropriate for them to turn around and use that cheap money to trade for profit. And that is especially true when this kind of trading often puts banks in direct conflict with their customers' interests.

My message to members of Congress of both parties is that we have to get this done. And my message to leaders of the financial industry is to work with us, and not against us, on needed reforms. I welcome constructive input from folks in the financial sector. But what we've seen so far, in recent weeks, is an army of industry lobbyists from Wall Street descending on Capitol Hill to try and block basic and common-sense rules of the road that would protect our economy and the American people.

So if these folks want a fight, it's a fight I'm ready to have. And my resolve is only strengthened when I see a return to old practices at some of the very firms fighting reform; and when I see soaring profits and obscene bonuses at some of the very firms claiming that they can't lend more to small business, they can't keep credit card rates low, they can't pay a fee to refund taxpayers for the bailout without passing on the cost to shareholders or customers – that's the claims they're making. It's exactly this kind of irresponsibility that makes clear reform is necessary.

We've come through a terrible crisis. The American people have paid a very high price. We simply cannot return to business as usual. That's why we're going to ensure that Wall Street pays back the American people for the bailout. That's why we're going to rein in the excess and abuse that nearly brought down our financial system. That's why we're going to pass these reforms into law.