Jan 28th 2010 | From The Economist print edition
FOR investors the most dangerous words in the English language are “this time it’s different.” For governments and financial policemen they are “never again.” Yet that is what Barack Obama promised on January 21st when he announced proposals to stop banks trading on their own account and to limit their involvement in hedge funds and private equity: “Never again will the American taxpayer be held hostage by a bank that is too big to fail.” Can he live up to this promise? Or is it destined to become a YouTube classic, played endlessly in half a decade or so, after another banking implosion?
The goal of putting an end to governments’ blanket implicit guarantee of banks is a good one. Politically the guarantee is poisonous: accusations of a “socialism for the rich” are hard to refute when bailed-out bankers enjoy fat bonuses during a severe recession. Economically it makes another crisis more likely by giving banks every incentive to grow bigger and take more risk. The political theatre of grand declarations has something to be said for it too. Voters cannot be sold technicalities. They want to feel that their anger has been heard.
Technicalities matter, however, and Mr Obama’s proposals do not live up to their billing. To talk, as some commentators have done, of a new Glass-Steagall act, the Depression-era law that split commercial and investment banking until the 1990s, is wildly off the mark (see article). The administration seems to define proprietary trading narrowly, as the stand-alone “prop desks” most banks have for betting their own money (anything broader would be unworkable). It’s easy to see why they do not deserve a public subsidy. It’s hard to see why banning them makes banks much safer. Prop desks are a small part of most firms’ activities and the same is true of banks’ investments in private equity and hedge funds. These activities did not play a leading role in the crisis.
It’s not that simple
The proposals also betray a desire to ring-fence deposit-taking firms and let everything else fry. However understandable, the reality is that investment banks, credit-card operators, insurers and even carmakers’ finance arms had to be bailed out. The system was too interconnected. The administration says that if a firm wants to continue prop trading (as Goldman Sachs might) it will lose the privileges banks get, such as federal deposit-insurance and access to the Federal Reserve’s discount window. So what? Changing the label and culling symbolic perks would not make a firm less of a threat if it failed. As things stand the state would still have to step in.
The administration appears to have broken ranks with regulators elsewhere in the world. But in truth, like them, it is relying on new capital and liquidity buffers to do most of the work of making banks safer. For the average bank, these will probably succeed. But no one has yet found a convincing mechanism to deal with outliers whose losses in a typical crisis are far too great for any reasonable safety buffer. What is needed is a way of pushing losses onto creditors without sparking a run that endangers the whole system.
One option is to break banks into bits that can default without dragging down other firms. Mr Obama is being advised by Paul Volcker, a former chairman of the Fed and a fan of this approach. But a Glass-Steagall split, forcing commercial banks to ditch their investment-banking arms, is pointless if investment banks still have to be bailed out. And banks might have to be ground into gravel rather than just broken in two. The smallest firm subject to the Fed’s stress tests in May had risk-adjusted assets of about $100 billion. If this were the minimum size of a systemically important firm, then America’s four big banks would need to be split into 48 separate companies to be small enough to fail. American policymakers will be acutely aware that there is almost no appetite anywhere else, except Britain, for breaking up banks.
The alternative is to find ways to allow a controlled default of part of banks’ balance-sheets. That will require the rejigging of their liabilities to include new forms of debt, as well as the creation of resolution authorities with enough power to impose losses on some creditors, but not so much that they terrify counterparties into running. That is a big task, which some banks will resist and which has been given no particular emphasis in the swamp of proposals being considered by Congress. If the president wants to keep his promises, this would be a good place to start.