"The best defence is a good offence," is a favourite cliché of US sports commentators and there are many on Wall Street who will find President Obama's latest move highly offensive. The defeat in the Massachusetts senatorial election has damaged the President. In sporting terms, it was what our transatlantic friends would call "a whooping". It means the Republicans can filibust his legislative balls. Healthcare? If you're lucky, pal. Cap-and-trade? Get-outta-here! What do you do when you sense your popularity waning? Find people less popular than yourself, the fattest kids in highschool, and pick on them. The banks have been ostentatiously unpopular since the beginning of his Presidency and now Obama wants to beat them up.
The assault on the Wall Street comes barely a week after the President announced a 0.15 per cent levy on all bank assets over $50 billion, which is expected to raise $90 billion for the US Treasury over ten years. The President now proposes new limits on both the size of the institutions and the scope of their activities. Banks holding retail deposits, which are insured by the US Federal Reserve (Fed), will not be allowed to engage in proprietary trading (where the bank trades using its own capital), nor will they be permitted to own, invest in or "sponsor" their own hedge funds or private equity (PE) groups. The idea behind the proposals is that those institutions which hold the money of ordinary Americans (in the form of retail deposits), and therefore enjoy protection from the state, should not be allowed to engage in the (supposedly) riskier side of finance. The man behind the plan is the White House Advisor and former Chairman of the Fed, Paul Volckner, who's nickname is "The Tall Guy" because, well, he's very tall (6ft 7in- they like to keep their nomenclature simple over that side of the pond). If it makes it through congress, the law will be called "The Volcker Rule" (because he thought of them, see?). It has been compared to the Glass-Steagall act (named after the politicians who... you get the picture), which was introduced in 1933, four years after the Wall Street Crash and banned retail deposit holding institutions from underwriting deals, effectively separating retail from investment banking. The law was repealed in 1999 (although certain provisions are still in force). Some people are calling these proposals "Glass-Steagall lite".
*What will be the impact on the banks? *
The short answer is no one knows. The proposals are currently extremely vague and they are likely to change beyond recognition during the congressional brawl that will inevitably break out before they can become law. But the banks are busy working out worst-case scenarios. No one knows exactly how the White plans to limit the size of financial institutions. It is already the case that banks are not allowed more than a 10 per cent share of the market for retail deposits. It seems likely that caps will be introduced in other areas.
Nor is there any certainty as to how the ban on proprietary trading will work. No one is even sure how this activity will be defined. If it is given the narrowest possible definition (the bank trading purely with its own capital for its own benefit) any prohibition is unlikely to hurt too much. Banks have already scaled down their activities in this area. However, a broader definition could restrict the business the bank does with its clients. It is common, in so-called "flow trades" on behalf of clients, for the banks to take a position (i.e. buy or sell securities on its own account), in effect acting as a middleman.
The banks are more scared of being stripped of their private equity and hedge funds. Obama's plans would end the obvious conflict of interest that arises when banks are able to invest their own capital into companies which they are also free to advise on mergers and acquisitions. No one is more concerned than Goldman Sachs, who dominate this area of the industry. The various funds in the Goldman Sachs Prinicpal Investment Area manage over $50 billion and generate over 10 per cent of the bank's revenues. Goldman uses the sheer size of PE arm to attract new advisory work. But the other Wall Street institutions also have sizable operations. J P Morgan Chase, for example, would hate to lose Highbridge Capital (its private equity arm with $21 billion under management). However, if the Volcker Rule is passed in an undiluted form they may be forced to sell off these assets on the cheap. This prospect would greatly please the private equity groups and hedge funds, who are sick of competing with the banks own in-house operations. However, the proposals would also prohibit the banks from investing in other funds. According to the research and consultancy firm, Preqin, 9 per cent of all capital managed by private equity groups in 2009 came from US banks. Whether the sector would be an overall winner is therefore a moot point. It is also unclear exactly what is meant by the ban on banks "sponsorship" of private equity and hedge funds. Could this include advisory fees? Would it apply to the banks' private wealth management businesses? The answer is blowing in the wind.
*What are the criticisms? *
It is hard to criticise a set of proposals which remain so vague, and yet many on Wall Street are giving it a good go. The vagueness, they say, is itself a problem. The last thing the industry needed is more uncertainty. They also accuse the White House of disrupting co-ordinated, international efforts to reform global banking regulations.
The most serious criticisms concern the substance of the proposals. The first problem is that the reforms are limited to deposit holding institutions. There are many other types of financial institutions which have long-term assets and potentially short-term liabilities (like Lehman Brothers). In other words, the proposals don't deal with, what is sometimes called, the "shadow banking system". These institutions would remain too big and, crucially, too interconnected to be allowed to fail. The markets would still view them as carrying the implicit backing of the state.
The second big problem concerns the ban on proprietary trading. Put simply, it won't make the banks safer. In fact, it could leave them more exposed. Though proprietary trading is sometimes called "casino banking", the risky business is really good, old-fashioned lending. The financial crisis, after all, had its origins in the US mortgage market. Derivatives trading can be a way of reducing (hedging) these risks as well as a form of gambling (speculation). A strict ban on all forms of proprietary trading may make the banks less safe.
*What next? *
The detail of the proposals will come in the form of complex legislation which must pass both the House of Representatives and the Senate. This is likely to be a long, drawn out process, giving ample opportunity for Wall Street's powerful lobbying machine to get to work. With their new power to filibuster legislation in the senate, the Republicans could, in theory block any plans becoming law. However, given the public hostility towards bankers this would be an unwise political strategy. They are more likely to seek to distort or dilute any legislation with an avalanche of amendments. Democrats hope to pass a law by the end of the year. The success or failure to pass a popular bill may well have a major influence on the Congressional mid-term elections in November and so on the future of the Obama administration. For the banks, the stakes are clear. As the billionaire financier, George Soros, put it: "If the legislation were carried through, it would certainly mean the end of Goldman Sachs as we know it." Don't expect them to go down without a fight.