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09:28 AM
Dr Richard Reid, Director of Research at the  International Centre for Financial Regulation
Dr Richard Reid, Director of Research at the International Centre for Financial Regulation
Commentary
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Obama Proposes Measures to Restrict Size and Activity of Major Banks

Obama Proposes Measures to Restrict Size and Activity of Major Banks


In a move which took markets somewhat by surprise, US President Mr Obama last week announced significant proposals to curb the size and structure of a certain components of the banking system. There is of course much discussion in a number of countries at the present time about what measures should be taken by policy makers in response both to the causes of the financial crisis and the behavior of many banks since the crisis. Many politicians and members of the public have been dismayed at the payments of bonuses by many banks which are either receiving tax payer support in one form or another or which are seen still to be restricting credit. In the US the focus on the financial sector may have sharpened in the wake of the electoral setback suffered by the Democrats this week, but there was already a deep rooted move towards somehow getting the banking system to bear a greater share of the costs of the financial rescue packages and to curb risky activity. By bringing Paul Volcker back into the frame, President Obama has also put a question mark over the future of the Treasury Secretary Tim Geithner.

It is to be remembered that these are "just" proposals at this stage and there will no doubt be much arguing and debating in the weeks and months ahead. In essence the President's proposals aim to restrict proprietary trading and investment at the banks. Hence, some have commented that this move is harking back to the Glass-Steagall Act of 1933 (Mr Volcker apparently preferring to term it a return to the "spirit" of that Act). The plans apparently aim to cut altogether proprietary investments and the sponsorship of hedge and private equity funds by banks, with the government also citing potential conflicts of interest issues. Echoing other initiatives, the thrust of the measures is to create some kind of separation between institutions that benefit from deposit insurance and other official support measures from becoming exposed to undue risk. Over the past months some of the plans to change banks capital requirements have similarly taken aim at the riskier part of banking and indeed some academics have suggested that parts of the banking system - the riskier parts- could be treated as the dot-com companies of the 1990's. They can have a high return-risk profile (and remuneration policy) but should also bear the ultimate sanction - failure.

Of course these proposals, coming at a time as we noted earlier this week, when there seemed to be some backing away from aggressive reform in the financial sector, will stoke up the debate at the international level about the best way to proceed. It remains to be seen if this step in the US helps or hinders the attempts by the G20 and Financial Stability Board to foster international cooperation. (it has been reported that the Financial Stability Board will present its own proposals for regulating large financial institutions in July – see link below or click here to view )

As these proposals move into the public domain in more detail there is bound to be an acrimonious debate: times have moved on since the 1930's and how to define certain types of banking activity will be a major task. Part of the attraction of the large, complex banks is that they have customers with large complex financing demands. Not the least of the issues could be how to identify what is proprietary trading. Finally, the President apparently is seeking to have the power to limit the size of banks (involving in part caps on deposit market share) should they be deemed to raise questions of systemic risk. How in practice would such a decision be reached? Over what period will such changes have to be introduced?

Whatever happens, these statements today have significantly re-kindled the interest in how best to treat the banks in the wake of the financial crisis. Of course this increased uncertainty could further affect banking behavior and dampen the recovery in credit growth. There may also be issues about competition with other parts of the financial system not subject to the full force of these measures. All in all, the coming months are set to see an intensified period of lobbying - on both sides of the Atlantic.

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