The global banking landscape will be transformed if the new bank rules announced overnight by US President Barack Obama are enacted.
The new rules will severely curb the activities of the big US banks. Commercial banks that take deposits from customers will be banned from proprietary trading – which means investing or trading using their own money.
In addition, they will not be allowed to own, invest in or sponsor hedge funds or private equity firms.
Obama also plans to limit the size of any single bank firm in relation to the entire financial sector. At present, there is a cap of 10 per cent on the share of insured deposits any one bank can account for. The new rules will widen this to take into account non-deposit funding.
It’s not surprising that US banks stocks were sent reeling last night.
The new rules will substantially reduce the potential profitability of the big US banks.
You only have to look at Goldman Sachs’ record fourth quarter results to see how important income from proprietary trading is for the big US banks. Goldman made $6.4 billion from proprietary trading in the fourth quarter, down from $10 billion in the third quarter.
But the new rules will also hugely reduce the potential that colossal bets made by the big banks will bring the financial system to the brink of collapse, as happened in 2008.
Obama has dubbed the new rules the ‘Volcker rules’ because they strongly reflect the thinking of Paul Volcker, the former Federal Reserve Board Chairman.
Volcker, who heads Obama’s Economic Recovery Advisory Board, has long argued that the country’s biggest banks should be restricted to commercial banking and prohibited from using their own money to engage in risky trading.
Volcker argues that regulation by itself won’t work. If they’re allowed to, big banks will always chase profits, and take risks. And that means that there is always potential that the big banks will get into trouble.
That’s why he’s being arguing – and Obama now agrees – that there should be a strict division between commercial banking activities and proprietary trading.
Under the new rules outlined by Obama overnight, the big US banks will look a lot more like the big four Australian banks.
They’ll be commercial banks, which take deposits, lend to households and businesses, and manage the country’s payment system. They’ll also be allowed to trade securities for their customers, but not for themselves.
Their profits will come from providing a service to their customers. This will be less than their profits they made in the past. After all, the reason the big US banks went into risky trading as a way to supercharge their profits, was so they could pay higher bonuses.
But, it also substantially reduces the risk that these banks – which are crucial to the health of the global system – will fail. And if they do get into trouble, there’ll be an explicit understanding that the government will rescue them.
In contrast, there will be a new class of investment houses which will be allowed to buy and sell securities using their own money. They’ll even be allowed to borrow money and leverage these trades, magnifying the potential profits, and the risks involved.
But these investment houses will not have access to government-insured deposits to finance their trading. And they will not have access to the Fed’s discount window.
If an investment bank fails, the US government will supervise an orderly liquidation. The big banks will no doubt howl that these new rules will hamper financial innovation, and will hold back the US as a global financial centre.
The US government is prepared to run that risk – and the fact that it is, reflects Volcker’s skepticism about the benefits of financial innovation.
Last month, Volcker told a conference of bankers that he was yet to see a shred of evidence that financial innovation benefited the economy. He then named the ATM as the most important financial innovation of the past 25 years. It’s clear that Obama now agrees.
This article first appeared on Business Spectator.
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