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Would New Bank Rules Really Prevent Another Crisis?

Sewell Chan and Eric Dash|The New York Times
Friday, 22 Jan 2010 | 9:50 AM ET

President Obama wants to cut down to size those too-big-to-fail banks. But his vow on Thursday to rewrite the rules of Wall Street left many questions unanswered, including the big one: Would this really prevent another financial crisis?

President Barack Obama
Photo By: Pete Souza
President Barack Obama

The president’s proposals to place new limits on the size and activities of big banks rattled the stock market, but banking executives were perplexed as to how his plan would work. Indeed, many insisted the proposals, if adopted, would do little to change their businesses.

Moreover, it was unclear if the twin proposals — to ban banks with federally insured deposits from casting risky bets in the markets, and to resist further consolidation in the financial industry — would have done much if anything to forestall the crisis that pushed the economic system to the brink of collapse in 2008.

Mr. Obama appeared to be leaving crucial details to be hashed out by Congress, where partisan tussling has already threatened another reform the president supports — the creation of a consumer protection agency that would have oversight over credit cards, mortgages and other lending products.

Wall Street figures, many caught off guard by the news, reacted cautiously.

“I am somewhat skeptical about how much the federal government can actually regulate,” said John C. Bogle, the founder of Vanguard, the mutual fund giant. “We need to try, but all the lawyers and geniuses on Wall Street are going to figure out ways to get around everything.”

Indeed, Mr. Obama acknowledged that “an army of industry lobbyists” had already descended on Capitol Hill, but vowed, “If these folks want a fight, it’s a fight I’m ready to have.”

Shares of big banks — potentially the biggest losers should the proposals be enacted — fell sharply, dragging the broader market down by about 2 percent. Even as the markets stumbled, Mr. Obama — still stinging from the Democrats’ loss on Tuesday of the Massachusetts seat formerly held by Senator Edward M. Kennedy — ramped up his populist approach, one week after he proposed a new tax on large financial institutions to recoup projected losses from the 2008 bailout.

Mr. Obama said the banks had nearly wrecked the economy by taking “huge, reckless risks in pursuit of quick profits and massive bonuses.”

The administration wants to ban bank holding companies from owning, investing in or sponsoring hedge funds or private equity funds and from engaging in proprietary trading, or trading on their own accounts, as opposed to the money of their customers.

Mr. Obama called the ban the Volcker Rule, in recognition of the former Federal Reserve chairman, Paul A. Volcker, who has championed the proposal. Big losses by banks in the trading of financial securities, especially mortgage-backed assets, precipitated the credit crisis in 2008 and the federal bailout.

It was not clear, however, how proprietary trading activities would be defined.

Officials said that banks would not be permitted to use their own capital for “trading unrelated to serving customers.” Such a restriction would most likely compel banks that own hedge funds and private equity funds to dispose of them over time. Officials said, however, that executing trades on a client’s behalf and using bank capital to make a market or to hedge a client’s risk would be permissible.

Federal regulators have already leaned hard on banks to curb pure proprietary trading, and the banks expect that regulators will demand more capital if they keep making risky bets, making the practice far less profitable.

Some of the biggest firms, applying a narrow definition, say that pure proprietary trading constituted less than 10 percent of their revenue, and in some cases far less. Morgan Stanley , for example, already abandoned all but two proprietary trading desks last year.

The Buckingham Research Group estimated that the new rules would reduce revenue at Citigroup , Bank of America and JPMorgan Chase by less than 3 percent. Goldman Sachs , which typically derives a tenth of its revenue from such trading, said it would be able to contend with the new rules.

“I would say pure walled-off proprietary-trading businesses at Goldman Sachs are not very big in the context of the firm,” David A. Viniar, the firm’s chief financial officer, said in a conference call.

Mr. Obama also is seeking to limit consolidation in the financial sector, by placing curbs on the market share of liabilities at the largest firms. Since 1994, the share of insured deposits that can be held by any one bank has been capped at 10 percent.

The administration wants to expand that cap to include all liabilities, to limit the concentration of too much risk in any single bank. Officials said the measure would prevent banks at or near the threshold from making acquisitions but would not require them to shrink their business or stop growing on their own.

The Obama administration said the new proposals were in the “spirit of Glass-Steagall” — a reference to the Depression-era law that separated commercial and investment banking, which was repealed in 1999.

Economists have debated whether the repeal of that act contributed to the crisis. The two big investment banks that imploded, Bear Stearns and Lehman Brothers, were not commercial banks, and Goldman Sachs and Morgan Stanleyconverted to bank holding companies only after the system started to come unglued.

The industry was left buzzing with questions about timing and scope. Officials said the new restrictions would apply to overseas firms, like Barclays and UBS , with large American operations, but it was not clear how — or whether — foreign governments would go along. Officials also said the proposal called for a “reasonable transition period” for firms to comply with the rules, but the timetable was not specified.

Timothy F. Geithner, the Treasury secretary, and Lawrence H. Summers, the president’s chief economic adviser, developed the proposals at the request of the president and worked closely with Mr. Volcker, according to White House officials. The plan was completed over the holidays and submitted to the president with a unanimous recommendation from the economic team.

While Mr. Geithner and Mr. Summers debated concerns that proprietary trading was not at the heart of the recent crisis, they concluded that reforms needed to address potential sources of risk in the future.

Reaction on Capitol Hill also was muted, partly because neither party wanted to be seen as beholden to unpopular banks. The House bill passed last month would consolidate oversight, require stronger capital cushions for the largest banks and impose regulation of some derivatives. In many ways, the new White House proposal amplifies provisions in that bill that would have left regulators discretion over proprietary trading and excessive liability.

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