The most eloquent American politician of a generation declared: “You shall not crucify mankind upon a cross of gold.” William Jennings Bryan, a future Democratic presidential nominee, issued his famous call to populist arms against the power of finance in 1896. That protest was echoed yesterday in President Obama’s declaration of readiness for a fight with Wall Street. Mr Obama wants to impose limits on the size of US banks and the amount of risk they can take. It is a judgment rooted more in short-term politics than in economic needs. If the fight is joined, it will be a battle of attrition in which both Mr Obama and the banks will be the losers.
Banks have got bigger in the past decade. Mr Obama wants to make them smaller again, by limiting the liabilities that they take on. He also wishes to restrict what a bank can do. Mr Obama proposes that a bank that takes customer deposits should not be allowed to own or invest in hedge funds or private equity funds, or trade for its own account (known as proprietary trading).
Mr Obama’s indictment of banking irresponsibility was cogent. His proposals are nothing like as well constructed. The global recession of 2009 was brought about by a dysfunctional banking system. Bankers believed that new and complex financial instruments had reduced the risks of lending. Instead these products contaminated the whole financial system with bad debts.
Hedge funds can borrow to invest, and sell stocks they do not own. Private equity funds invest in assets that are difficult to trade. Proprietary trading takes risks with a bank’s own capital. Taking retail deposits is different from these high-risk activities and should be insulated from them. But this is a fairly minor point. Hedge funds and private equity funds did not bring down the financial system. The banking crisis was sparked instead by the biggest and most tightly regulated ones of all: commercial banks.
These banks (which take customer deposits) used to be barred from owning investment banks, which lend money to companies and conduct transactions in the capital markets. The legislation that mandated this separation was repealed in 1999. Since then, American banks have consolidated. Mr Obama believes that it is important to make the banks smaller, so that if one fails then its impact on the economy is limited. No longer would the taxpayer have to give an open-ended guarantee to rescue a failing bank, while not sharing in the profits of success.
But banks created the crisis not because of size but out of cluelessness. A typical bank is many times more highly leveraged than a hedge fund. It is better to limit banks’ borrowing than restrict their activities. An integrated bank, combining retail and securities businesses, can generate economies of scale and thereby make higher profits. The crisis has demonstrated that there must be more things for a bank to achieve than returns for shareholders. But there is no sense in placing limits on banks that contribute little to the stability of the financial system while making it more difficult to turn a profit.
In the UK, the Treasury, the Conservatives and the Liberal Democrats have all welcomed Mr Obama’s proposals. Theirs too is a short-term populist response with little economic logic. A thriving financial services sector is essential to an efficient economy. Tight financial regulation is essential, but badly designed measures will merely drive business to other banking centres. The City of London may prove to be the biggest beneficiary of Mr Obama’s campaign, apparently to the discomfort of British politicians. There is nothing wrong and much to prize in a bloated financial sector, if that is the way that the UK corporate sector can generate profits. It is past time to stand up for bankers.
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