03/24/2010 05:12 am ET Updated May 25, 2011

Obama Announcement Revives Regulatory Push

President Barack Obama's new proposal to limit megabanks' trading activities wouldn't actually break up "too big to fail" institutions -- but it does reflect a more combative, populist attitude from the White House that could go a long way toward putting some spine back into the movement to re-regulate the financial industry.

In his remarks Thursday, Obama laid out a proposal to require banks and the companies that own them to divest from any hedge funds or private-equity firms they own, invest in or sponsor. He also called for a cap on a firm's liabilities relative to market share, so a small group of banks won't be able to hold an inordinate amount of control over the financial system. And he would require banks and their parent companies to halt all Wall Street-like trading they do strictly for their own profit. If the banks don't want to quit those businesses, then they can no longer be banks.

Even as public outrage has continued to grow against Wall Street -- where bailed-out and taxpayer-subsidized firms are recording tremendous profits and bonuses -- the nation's biggest banks have been remarkably successful at slowing and weakening the legislative drive to re-regulate them.

This latest effort, though, is where the real fight will begin, says Simon Johnson, a former chief economist for the International Monetary Fund who's now a professor at MIT and an influential economics and policy blogger.

"Everything else was a warm-up act," Johnson said.

The reason why is because these latest proposals strike at how big Wall Street banks can make a lot of money. After years of loose lending policies and giving mortgages and credit cards to anyone with a pulse, big banks like JPMorgan Chase, Citigroup and Bank of America are losing money as those loans sour and they're forced to reserve tens of billions for anticipated future losses.

But big banks can make big bucks with their Wall Street-like trading operations. Bank of America's global-markets unit turned a $7.2 billion profit in 2009 versus $6.3 billion for the entire bank. JPMorgan Chase's investment bank division enjoyed a $6.9 billion profit for the year, making up 59 percent of the firm's total profits. Goldman Sachs's trading operation raked in $34.4 billion in revenues in 2009, more than three-quarters of the firm's total revenue.

And right now, they have a huge advantage over other financial institutions: a massive, continuing taxpayer subsidy. The financial markets view the megabanks as genuinely being too big to fail, so that the government will step in should any of them be in serious danger. Goldman CEO Lloyd Blankfein acknowledged that last week during a hearing on Capitol Hill. The result is that creditors know loaning them money is essentially risk-free, and are willing to lend at lower rates than if there was a chance they would fail.

Also, banks of all sizes enjoy access to the Federal Reserve's discount lending window, which supplies them with cash at low cost that they can access at anytime. The idea that they can use that money to fund their trading is what has members of Congress like Rep. Paul Kanjorski (D-Pa.) up in arms.

"Financial firms that want to play in a casino need to have their own resources to cover their bets and not assume that tax dollars are available in reserve if their bets fail," he said in November.

Banks also have federal deposit insurance, which allows banks to use deposits to fund their trading activities -- knowing that if they ever failed, taxpayers would foot the bill to protect the depositors.

It's this kind of behavior that Obama now says he wants to limit. Combined with more stringent regulation, and requirements that firms cut back on their borrowing relative to their capital and keep more cash aside to protect against losses, his proposals should theoretically limit the kind of crazy borrowing and reckless investing that led to the financial crisis.

But there are a few catches.

For one, Congress has to approve the plans. Also, existing big banks will not need to shrink or be broken up, despite the fact that the country's four biggest bank-holding companies -- Bank of America, JPMorgan Chase, Citigroup and Wells Fargo -- collectively hold $7.4 trillion in assets. To put that in perspective, that's 52 percent of the country's total output in 2008.

Johnson said he is "quite disappointed" with the proposal's stated goal of limiting future megabank growth, as opposed to cutting them down to size. He argues that the big banks are so big that if they ever needed a bailout, "the government would give them one."

"The litmus test is to see if Goldman Sachs is forced to break up into four or five pieces," Johnson said of Wall Street's most successful and powerful firm. "Then it would be victory. Sanity would be restored.

"But if Goldman is kept at its current size, then this will have failed," he said.

Goldman Sachs has $883 billion in assets, according to its latest regulatory filing with the Federal Reserve. Johnson said the firm should be in the $100-200 billion range, at most. It had about $270 billion in assets in 1998, he added.

And another catch: There's still little clarity on some key details of Obama's proposal.

For example, while the proposal aims to cap liabilities, it doesn't spell out what, if anything, it will do about banks' control over other areas of the market. The Big Four banks control much of the credit card industry as well as home mortgages. Also, thanks to bank mergers brought about by the collapse in 2007-08, Bank of America and Wells Fargo are both currently in violation of a federal law that limits banks' share of national deposits to 10 percent. There wasn't any word on whether BofA and Wells would be forced to divest.

Also, there's no mention of how it will treat the trillions of dollars the big banks keep off their balance sheets by exploiting traditional accounting rules. Some banks keep more off their books than on -- Wells Fargo has more than $2 trillion in assets off its books, nearly double the $1.2 trillion it has on its balance sheet. If the proposal only addresses the liabilities on banks' balance sheets, then there will be an incentive to move things off the books. Regulators and investors would be in the dark.

And while much fuss has been made about the proposal to eliminate proprietary trading (essentially trading with a firm's own money), it's actually much harder to enforce.

"It's going to be tricky," said a senior official with one of the federal bank regulatory agencies. "On the one hand, there are transactions that a bank does that are customer driven and are probably pretty clearly defined and everybody knows what they are. And then at the other end, there's a whole bunch of transactions that are clearly being done on their own behalf.

"But there's this big area in the middle, where during the day they're doing a whole bunch of things for their customers, and they're doing them on their own book. At the end of the's going to be hard to know which ones are proprietary and which ones are solely on behalf of customers.

"And maybe there's going to be a little bit in there anyhow that they did for themselves."

Douglas Elliott, a former investment banker and currently a fellow in economic studies at the Brookings Institution, said that firms that want to remain banks can just dump their specially-designated proprietary trading units and move those traders to divisions that are trading for clients, mixing it all together and making it harder for regulators to distinguish between what's done solely for a firm and what's done just for clients.

Similarly, the ban on owning hedge funds and private equity funds doesn't prohibit banks from lending to them or providing financing, which they already do.

"That would still be essentially allowed under this proposal," another senior administration official said in an interview.

So while banks wouldn't be allowed to own a hedge fund, they could provide all of a hedge fund's funding, for example.

"This is not the silver bullet. This is part of a broader plan," the official said.

And Johnson expects the banks to fight.

"Banks are going to push back hard," he said. "[JPMorgan Chase CEO] Jamie Dimon will be living in [Treasury Secretary Timothy] Geithner's office."