On Thursday, President Obama announced his most sweeping financial reform proposal to date, calling for a limit on the size of the nation's financial institutions. His proposal bars commercial banks such as Citigroup, JP Morgan, Bank of America, Morgan Stanley, and Goldman Sachs from sponsoring private equity and hedge funds and engaging in proprietary trading.
This is a sensible proposal. It gets to the core of the underlying causes of the financial crisis, and Congress should pass legislation to ensure Obama's proposed reforms become law.
Much of the public's confusion about the financial sector comes from a fundamental misunderstanding of its various functions. For the purposes of our discussion, there are two broad mechanisms by which banks make money.
The core function of banks is to take deposits and to lend. This basic process of credit creation is much like a utility - it is the lifeblood of the economy, similar to electricity and other basic infrastructure provisions. Without a stable system of safeguarding deposits and lending, our economy could not operate. Banks provide this service to individuals, small businesses, and corporations.
In addition to run-of-the-mill banking, our country's financial institutions second primary function is to serve as a "broker-dealer" in the market for financial assets. In essence, these major financial institutions are middle men in various asset markets, much like a supermarket is to food, only the prices on the shelves are highly volatile, and entire swaths of produce can go bad without warning, causing the whole store to go up in flames.
Broker-dealer functions are as follows:
1) Market making - Broker-dealers provide liquidity to the marketplace, showing prices to investors. The difference between the price at which they are willing to buy an asset and the price at which they are willing to sell is called the "spread," and is the most conventional form of broker-dealer profit making. A greater reliance on electronic exchanges and industry competition has put downward pressure on spreads in recent years, causing banks to look for other means of making money, including:
2) Securitization - This is how banks turn thousands of residential mortgages, credit card receivables, leveraged loans, and other products into the veritable alphabet soup of securitized products like CDOs. Much of the large losses faced by the banks last year were a direct result of their holding onto their securitized products, many of whose cashflows ceased as defaults rose.
3) Prime Brokerage - This branch coordinates lending with the banks' institutional clients. Imprudent prime brokerage lending presaged the systemic crisis of Long-Term Capital Management's failure a decade ago.
4) Proprietary Trading - This is the most speculative activity in which a bank can engage. Here, they deploy their own capital to make bets in different asset markets. Often, these bets are amplified by leverage, increasing bets' upside but also increasing their downside.
Consider the perversity of combining all of these activities into one financial behemoth. At the height of the financial crisis, Goldman Sachs sold securitized products to their clients like A.I.G.. Knowing that these assets were of dubious quality, their risk managers purchased insurance on the companies to whom they sold these assets. Additionally, Goldman's proprietary traders bet on these assets falling in value. Arguably, Goldman precipitated falling prices on bad assets that they created in order to profit on the weakness of their clients. This is how the modern financial system operates.
Back to Obama's proposal, limiting proprietary trading will necessarily decrease the risk taking ability of commercial banks. The real problem that Obama must contend with is that these broker-dealers are attached to conventional banks. This allowed banks like Citigroup and Bank of America to fund their speculative bets using deposits - a cheaper source of capital, certainly, but also a cause of being systemic.
Critics might claim that this plan does not wholly prevent another financial crisis. I agree - banks will always to find ways to defy financial stability. But closing this door to speculation is still prudent.
This proposal is Obama's first honest attempt to address the problem of too big to fail financial institutions. Many of the specifics of the proposal must be addressed, in particular coding what exactly constitutes a "proprietary trade."
But the spirit of Obama's proposal has merits on several bases. Politically, this should be a home run, capturing populist outrage at billions of dollars of bank bonuses in a time when 10% of Americans are out of work. Elected in part because of his seeming bipartisan appeal, Obama should woo moderate Republicans, selling them on the ideology of his plan (which was crafted by a Republican central banker, Paul Volker), namely that its passage will prevent the need for further "socialist" bailouts. Socially, this assuages a nagging sense of injustice that many Americans feel regarding Wall Street's seemingly special status inside the Obama White House, with insiders like Larry Summers and Timothy Geithner crafting economic policy. Finally, on economic grounds, having too big to fail speculative giants conflated with everyday lending is simply impermissible. Obama's plan clearly fixes this.
The electorate should not lose sight of Obama's courage. He is directly attacking thirty years of financial market deregulation and mismanagement that led to the crisis. Perhaps his likely defeat in health care reform has finally showed Obama that he must dirty his hands in the name of good policy. It will be a long slog before this proposal has a chance at passing. Let's hope Obama's luck might change before then.