Just over a week ago, the Obama Administration waged war on Wall Street.
President Obama has proposed financial reform that would limit the size and activities of the largest U.S. banks by separating proprietary trading, hedge funds, and private equity operations from banking (taking deposits and making loans). Theoretically, these reforms would simultaneously reduce the size of these banks and curb risk-taking.
Assuming that the new proposal passes the Senate, how effective will Obama’s proposal be? Will it ensure financial stability and long-term economic growth for the U.S.? Not necessarily. Here’s why.
Although I do agree that regulations designed to mitigate risk at “megabanks” can contribute to a stable economy and is the right long-term policy, Obama’s timing introducing these reforms could not have been worse.
In a political move to deflect attention away from the Democrats’ huge loss in Massachusetts jeopardizing the healthcare reform, Obama decided to announce his plans for financial reform only a few hours after Goldman Sachs reported better-than-expected earnings attributable, in part, to restricted pay.
The jubilant news that the financial sector, a crucial element to the growth of a nation’s economy, has finally shown evidence of stabilizing was crushed by Obama’s new proposal.
The proposal even called Federal Reserve Chairman Ben Bernanke’s confirmation to a second term into question. (He was confirmed this week by a 70-30 vote, although 11 democrats voted against the confirmation.)
All of a sudden, the prospect of a stable economy recovery seems to have dissipated, and replaced with panic and uncertainty.
Banks are Crucial for Recovery
An economic recovery will require a stable financial system so banks can lend to small businesses, advise firms on raising capital, and spur on the growth of businesses (so that business can hire workers again). With that in mind, a fragile economic recovery is not the best idea to stage a battle with the big players on Wall Street.
By creating greater uncertainty on the profitability and structure of large banks, Obama has, for now, sabotaged any impending recovery. If Obama’s proposal passes, his reforms will hit lucrative divisions of every major U.S. bank…and hard.
Goldman Sachs’ proprietary trading division, for example, which accounts for about 10 percent of the firms’ total revenues, would suffer; JP Morgan Chase’s successful Highbridge Capital hedge fund would be separated from its parent company; Morgan Stanley’s hedge fund and proprietary trading units would be affected; and so on.
When regulations eat away at banks’ profits from these divisions, the banks will have less to lend. That means the economy may continue to drag its feet, slowing the process for a full recovery. So if Obama wants to create more jobs through small businesses, he needs to stabilize the banking system first.
Same Old Lesson
In 1933, the U.S. passed the Glass-Steagall Act in the wake of the 1929 stock market crash. The act separated commercial banks from investment banks, which restricted commercial banks taking on speculative bets with depositors’ money. But Congress repealed the Glass-Steagall Act in 1999 because there was debate over how restricting financial innovation could hurt the industry. Many argued that if banks could diversify their operations, this could lead to a more stable sector.
Now, Obama’s financial reform proposal, though not necessarily the same as the Glass-Steagall Act, certainly echoes it. Will the same debate about limiting market innovation surface again?
Progress is the Result of Careful Risk-Taking
Innovations that improve our standard of living always come with a risk of failure. The Internet boom of the 1990’s revolutionized how we communicate, obtain information, and shape businesses. However, it ended in the early 2000’s with thousands of small online businesses failing, ultimately leading to a recession.
The Internet has been one of the most influential innovations in recent years. It took several thousands of small online businesses to fail to end up with today’s Internet powerhouses such as Amazon, eBay, and Google.
Likewise, financial innovation that improves efficiency of the free markets can only be developed through risk-taking. Unfortunately, the current financial crisis accelerated with the securitization of mortgages during the time of the seemingly never-ending real estate bubble. The good news is that we can learn from our mistakes, making progress towards greater transparency and efficiency.
So is Obama’s new proposal the cure for stabilizing large banks? Although to American’s angry with Wall Street’s past missteps the regulations may sound great, we can’t believe that we’re out of the woods just yet. There are more questions now than before, which means that we may face an even longer recovery period.
What do you think? Do you agree that tighter regulation on Wall Street is a bad idea or think that the Obama administration is doing the right thing? Should the same banks that take our deposits and give us mortgages be allowed to continue running riksy proprietary trading divisions and hedge funds? Share your thoughts in a comment.