The President's Bank Reforms Don't Add Up

After the Democrats' disaster in Massachusetts last Tuesday, President Obama appears to be flailing. Gone is the cool and measured demeanor that made him look presidential when the financial crisis struck during the 2008 campaign. Instead, the financial reform proposals he advanced later in the week seem to reflect political panic--a desperate attempt to appeal to the populist sentiment against Wall Street. Unfortunately, they also reflect a limited understanding of good financial or banking policy.

First, Mr. Obama has proposed to limit the size of banks or their holding companies, or both. The trouble with limiting the size of these institutions is that no one has the faintest idea what the right size is. What's more, if the purpose of the size limit is to prevent a bank or bank holding company from being or becoming too big to fail, we have to know what size would cause a failed institution to cause a financial train wreck. No one knows that, either. Under these circumstances, it's hard to take such a proposal seriously.

Second, Mr. Obama says that some firms should be prohibited from engaging in "proprietary trading." The White House announcement seems to apply to both banks and bank holding companies, but there is a huge difference between them. A bank is chartered by the government, its deposits are insured, it can participate in the U.S. payment system, and it has access to the Fed's discount window. None of these things is true of a bank holding company--which is an ordinary corporation that controls a bank.

Requiring banks to continue to lend to real estate, because they have few other alternatives, virtually guarantees another banking crisis in the future.

Because banks are government-backed, and privileged in many ways, their activities are limited by law and regulation. They are restricted in how they can use their insured deposits. The Glass-Steagall Act, despite what we constantly hear in the media and from people who should know better, still applies to banks; it forbids them from engaging in underwriting or dealing in securities. This should prohibit them from engaging in proprietary trading to the extent that this is dealing in securities. Bank holding companies, however, because they are not banks and not government-backed, can engage in any financial activity, including securities dealing. Why would we prohibit them from doing so when they are using their own funds?

Apparently, Mr. Obama is arguing that bank holding companies should be prohibited from proprietary trading because it's too risky. The trouble is that proprietary trading is a profitable business for many bank holding companies, and there is no evidence that it caused serious losses for either banks or bank holding companies in the recent financial crisis.

There are strong firewalls between the holding companies and the banks they control that prevent the activities of the holding companies from affecting their bank subsidiaries. If Mr. Obama's plan is adopted, many bank holding companies will have to give up profitable businesses or sell off their banks. But even that wouldn't really solve the problem, since some would contend that large financial institutions like Goldman Sachs and Morgan Stanley, even if they ceased being bank holding companies, would still be too big to fail.

But if we are going to stop Goldman Sachs and Morgan Stanley from taking risks in securities trading generally because they are too big to fail, why not stop securities trading by all large financial firms, such as investment banks or insurance companies? Even for a newly minted populist, this is a bit much.

There is one more factor to consider. Banks have been committing themselves increasingly to financing real estate. The reason for this is simple. Because they cannot underwrite or deal in securities, they have been losing out to securities firms in financing public companies--that is, most of American business other than small business. It is less expensive for a company to issue notes, bonds or commercial paper in the securities markets than to borrow from a bank.

Where, then, can banks find borrowers? The answer, unfortunately, is commercial and residential real estate.

Real-estate loans rose to 55% of all bank loans in 2008 from less than 25% in 1965. These loans will continue to rise in the future, because only real-estate, small business and consumer lending are now accessible activities for banks.

This is not a good trend, because the real-estate sector is highly cyclical and volatile. It was, indeed, the vast number of subprime and other risky mortgages in our financial system that caused the weakness of the banks and the financial crisis. Requiring banks to continue to lend to real estate, because they have few other alternatives, virtually guarantees another banking crisis in the future.

Since banks can never be let out of these restrictions as long as they are government-backed, one solution for banking organizations is to center their activities in the bank holding company which--because it is not government-backed--does not have to limit its range of activities. The fact that Mr. Obama now proposes to close off this one avenue through which banking organizations can be profitable is strong evidence that neither he nor his advisers, in attempting to lash out at banks, have thought through the long-term prospects and needs of the banking industry.

That might make good populist politics, but it is not responsible policy. Instead of trying to punish the banking industry, Mr. Obama should try to understand why banks have become so heavily invested in real estate.

Banks must remain restricted in their range of activities, but bank holding companies are not banks. The solution to the long-term problems of the banking business is not to narrow the activities of bank holding companies, but to broaden them.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy at AEI.

Photo credit: iStockphoto/Henrik Jonsson

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