Obama's Proposal to Take the Moral Hazard out of Banking

From the WhiteHouse.gov blog:

This morning the President proposed what he called "the Volcker Rule," named after one of the fiercest advocates for financial reform over the past year, and who has been particularly focused on addressing the issue of banks being "too big to fail." He also proposed addressing one of the clearest issues leading to the financial crisis of the past years, namely banks that stray wildly from their core mission: serving their customer. ...

For obvious political reasons, President Obama has decided to frame the debate in highly populist terms. His announcement included both threats and a call to arms:

... if these folks want a fight, it's a fight I'm ready to have. And my resolve is only strengthened when I see a return to old practices at some of the very firms fighting reform; and when I see soaring profits and obscene bonuses at some of the very firms claiming that they can't lend more to small business, they can't keep credit card rates low, they can't pay a fee to refund taxpayers for the bailout without passing on the cost to shareholders or customers -- that's the claims they're making. It's exactly this kind of irresponsibility that makes clear reform is necessary.

Whatever, dude, as we say out here in California.

When one sets aside the President's rhetoric and looks at the specifics, however, things start to look potentially quite reasonable. As the accompanying press release explains:

The proposal would:

1. Limit the Scope - The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

2. Limit the Size - The President also announced a new proposal to limit the consolidation of our financial sector. The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.

As regular readers know, I'm not a big fan of Obama. But let's give credit where credit is due. Both of these ideas make sense as a general concept, although the devil will be in the details.

Let's start with # 2. We are in the mess we're in today in large part because some banks were thought to be too big to allow them to fail. Investors, depositors, and managers of these banks figured that the government wouldn't let them go belly up if they got into big financial trouble. They acted as though they were getting an implicit subsidy from the taxpayer. Accordingly, they acted as though some substantial portion of the risks they took were being externalized onto the taxpayer. In effect, they were betting that they could gamble with the taxpayers money, which meant they took on risks that they would not have taken if they were playing with their own money. As we know, they were right. They were deemed to be too big to fail, they got bailed out, and that created a precedent confirming that the taxpayer will always subsidize risk taking by big banks.

One way of dealing with that problem would be to simply let the big banks fail. Unfortunately, some banks really are so big that their failure would have devastating systemic effects. I reluctantly supported the first round of bank bailouts precisely because the credit system really did come within a hairs breadth of seizing up. Constricting the size of banks so that none get too big to fail thus strikes me as a sensible plan.

Turning to part 1 of the proposal, deposit insurance creates a moral hazard. The presence of deposit insurance reduces the incentives of depositors to monitor the riskiness of the decisions bankers make. If the bank takes on risky trading for its own account, the depositors won't care, because the taxpayer will step in via the FDIC and make them whole (up to a very generous cap). Bank management won't care because, if the deal is profitable, they and the bank's stockholders reap the benefits, while if the deal fails, the taxpayer steps in to clean up the mess. When decision makers face only the consequences of a risk paying off and not those of the risk going south, they take too much risk.

Just as a private insurer has an economic incentive to restrict the risks its policyholders take (notice that your auto insurance policy probably doesn't cover accidents caused by racing), the government thus has an incentive to constrain risk taking by the banks it insures.

Part 1 of the proposal is commendable because it doesn't restore the Glass-Steagall rules that banned banks from engaging in securities underwriting. Those rules did little to protect the FDIC. Instead, they served mainly to insulate Wall Street's underwriting business from competition. Instead, Part 1 seems likely to focus on proprietary trading, which doesn't raise the same degree of concern about preserving competition.

My only hesitation about the proposal in Part 1 is that the rule extends to any "financial institution that contains a bank." The Bank Holding Company Act recognized that one could solve the moral hazard created by deposit insurance by requiring that diversified financial institutions set up a holding company structure in which insured banks and uninsured risky lines of business be held in separately incorporated subsidiaries. In theory, the limited liability of both parent and the bank subsidiary should insulate it from the debts of the risky subsidiary. In practice, however, I suspect things may not be that simple. Before making up my mind about the proposal, I'll need to go back and look at cases like AIG to determine whether limited liability could have insulated the parent from the bad subsidiary's misdeeds.

In any case, while there are lots of details to be ironed out, the President's proposal is a good starting point.

Even the WSJ's editorial board thinks so:

Phony populism aside, yesterday Mr. Obama introduced his first serious idea into the debate on reforming the financial system. In calling for an end to proprietary trading at firms with a federal safety net, the President showed that he now understands an important principle: Risk-taking in the capital markets is incompatible with a taxpayer guarantee. ...

Yesterday's announcement is a critical departure from the reform plan Mr. Obama introduced last year—largely incorporated in the House and Senate bills written by Barney Frank and Chris Dodd. Those plans all sought to expand the universe of too-big-to-fail companies eligible for taxpayer rescue. Mr. Obama has at last joined the most important policy discussion: How to eliminate the moral hazard now embedded in the U.S. financial system. Political assaults on banker compensation have done nothing to address this core problem that enables gargantuan bonuses.  ...

The Democrats appear to finally realize that too-big-to-fail is a problem to be solved, not the foundation of a modern banking system.

Obama's proposal now becomes an important test for the Republicans. Are they the nihilistic party of no that Andrew Sullivan accuses them of having become? Or are they prepared to step up to the plate and help govern? The GOP response to Obama's proposal will tell us a lot about those questions.

This is a good start on one of the most important issues facing the economy. The GOP should meet Obama halfway. Failing to do so will be strong evidence that they are not yet ready to be trusted with the reins of government.

Comments

[Wyatt]

Why meet Obama halfway? I realize that we don't know the details yet, but what is objectionable about the proposal. Getting political concessions from the other side just because you can, even if you agree with their objective, is petty.

Unless something evil slithers up out of this idea during the legislative process, I don't see any principled reason for Republicans to oppose it.

[Gerry LaMontagne]

Is there any chance at all that the "to-big-to-fail" line is just a bogeyman to justify government involvment? Given all the other things that experts don't seem to really know when it comes to economics, what's the likelihood that their predictions of catastrophe would have been correct here?

[Steve Bainbridge]

Wyatt: Consider "halfway" to be a metaphor for working together. We haven't seen the legislative language yet, so we don't know what might be in the weeds. The idea is sufficiently sound to justify a bipartisan effort, but negotiations on the details will be needed.

Plus, I think it would be perfectly legitimate for the GOP to condition support for this proposal on getting something else. For example, if I were running the GOP, I'd say to Obama: "We'll help you get this regulation passed, but in return you've got to give up your proposed bank tax."

[save_the_rustbelt]

"Turning to part 1 of the proposal, deposit insurance creates a moral hazard. The presence of deposit insurance reduces the incentives of depositors to monitor the riskiness of the decisions bankers make."

So little old ladies are supposed to monitor bank balance sheets (which are largely indecipherable) to determine risk levels?

That should work out really well.

[Stunned and Amazed]

"Turning to part 1 of the proposal, deposit insurance creates a moral hazard. The presence of deposit insurance reduces the incentives of depositors to monitor the riskiness of the decisions bankers make."

Wall Street financial analysts can't figure out the black holes that are the banks financial statements with the shadow/offshore banking system unreported, but somehow everyone else with little financial knowledge are somehow supposed to figure this out or want to?

I have an MBA in Finance myself and if I have to monitor the banks in order to put my savings in them, I'll simply use the mattress like everyone else.

The banks have simply voided their trust with the public...they are gamblers of the highest order. What reasonable person would entrust their money with these jokers if they didn't have someone guaranteeing it?