President Obama made a proposal to limit sizes and activities of big banks in order to reduce risk-taking and prevent the re-occurrence of future financial crises. The proposal is intended to remedy the negative externalities that have accumulated over the years as a result of::(a) repealing the Glass-Steagall Act in 1999 that separated commercial banks from investment banks; (b) allowing investment banks to borrow money from the Federal Reserve like commercial banks do; (c) permitting the investment banks to receive federal guarantees on borrowing; (d) covering the investment banks’ deposits by FDIC insurance; and (e) government intervention in mortgage lending and imposition of Fannie and Freddie on the housing market. Banks are scrambling to interpret the rules contained in the proposal which if passed will benefit regional banks at the expense of the big banks. I interpret these rules as follows;
1. Banks that borrowed money from the Fed, received funding from the government or borrowed from the money markets should be prohibited from investing this money in their own accounts with the purpose of making high profit. This limitation should limit the size of bank activities and reduce their risk-taking capability.
2. Banks should distinguish between sponsored//owned hedge funds and private equity funds that invest their clients’ money and those that invest their own money. This should apply to inherited proprietary trading units such as the one Fells Fargo inherited when it acquired Wachovia in 2008. The funds that invest the banks own money should be prohibited because they will low banks to leverage their own profits by taking on excessive risk.
3. Banks that take federally insured deposits should also be prohibited from owning or sponsoring private trading units in which they invest their money .
4. The tax on big banks is proposed at 0.15% of the difference between a big bank assets and the sum of its deposits and tier 1 capital (high quality capital such as common stocks and retained earnings). This means that the bank tax should fall on the banks’ risky assets. This is a gradual tax and it should not push banks to shed off risky assets too quickly. For more information on this rule see the link:
Still, this bank tax on risky assets does not define capital requirement son banks. It does tell us how to value assets on which we will impose taxes. Should we use mark to market as the valuation tool? Okay, it is supposed to reduce risky asset, but will it make the banks safe enough?
5. There should be limits on excessive bonuses that encourage banks to take extra risk and should be rules on who give reasonable bonuses.
Despite the fact that these proposed regulations are not comprehensive enough, I see them to be beneficial to the banks in the long run, although they will be perceived by banks to be harmful in the short-run because they will reduce their short-run profitability. We are moving into an era with increasing volatility as evident in the increases in the volatility measure VIX. Any increases in leverage by the banks in the future will hurt them in the long-run becaure increased volatility and leverage do not mix in the long-run. This conclusion should be obvious to the banks and their clients once the proposal or a variation of it becomes laws. The banks should become safer and sturdier.
Politically, financial reforms are more important at this time than health care reforms. They should have given the top priority by the Obama administration. They should define his presidency and determine his next term in office. Press on hard!
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