Two Cheers For Obama's Bank Reform Plan

Roger Bootle Daily Telegraph January 25, 2010

Accessibility links

Monday 25 January 2010 | Roger Bootle feed

Advertisement Website of the Telegraph Media Group with breaking news, sport, business, latest UK and world news. Content from the Daily Telegraph and Sunday Telegraph newspapers and video from Telegraph TV. Enhanced by Google Home News Sport Finance Lifestyle Comment Travel Culture Technology Fashion Jobs Dating Games Offers News by Sector Comment Personal Finance Markets Economics Your Business Blogs Finance Video Fund Game Evans-Pritchard Jeff Randall Damian Reece Edmund Conway Tracy Corrigan Jeremy Warner Liam Halligan Kamal Ahmed Home Finance Comment Roger Bootle Two cheers for Obama's plan to reform a seriously flawed industry What a difference a surprise election defeat can make, particularly when juxtaposed with the news of Goldman Sachs bonuses.

Roger Bootle Published: 6:19PM GMT 24 Jan 2010

Comments 5 | Comment on this article

The inspiration for President Obama's plans to restrict the activities of banks may be crudely political, and the proposals may currently lack substance and detail, yet nevertheless they mark a fundamental change of direction.

And they are consistent with what I argued for in my recent book, The Trouble with Markets. The need for government intervention in the financial system arises from two major sources. The first is that, in pursuing their own profit, bankers may be inclined to undertake risks which endanger the stability of the whole financial system and hence the economy – and precipitate the need for a huge bailout funded by taxpayers.

Related Articles Three cheers for Goldman Sachs profits and its bonuses Goldman Sachs: hero or villain? Bankers' bonuses: When greed gets the better of survival Barack Obama critics take aim at carbon reforms after health reform success A recession for the many, not the few

The second aspect is a series of micro issues to do with efficiency. Recently, huge bonuses have earned public opprobrium mainly because of the perception that these have been directly or indirectly funded by the taxpayer. Yet even when this isn't the case there is legitimate cause for public concern. Defenders of bankers' rewards will say that the activities that bankers perform are highly profitable. There is a good deal in this – although, I must say, bankers display a remarkable ability to get well rewarded even when their activities are not that profitable!

But there are two other key questions to answer. First, why is banking so profitable? Second, is it as valuable as it is profitable?

President Obama's proposals do not adequately meet either of these concerns. The idea of stopping banks from engaging in proprietary trading or holding stakes in deemed-to-be risky activities is a version of the Glass- Steagall separation between investment and commercial banks.

It will be difficult to draw the line clearly, not least because the making of markets in financial instruments, eg foreign exchange, from which clients derive all benefit, ordinarily involves banks having to take positions in the course of trading.

Nevertheless, this is n

Roger Bootle Published: 6:19PM GMT 24 Jan 2010

Comments 5 | Comment on this article

But there are two other key questions to answer. First, why is banking so profitable? Second, is it as valuable as it is profitable?

Nevertheless, this is not an insurmountable obstacle. There is the world of difference between this and the banks' own proprietary trading desks, where essentially traders gamble with the banks' capital. It should be feasible to force this activity out of banks and into hedge funds, where the activity belongs, while still allowing at least some market-making within banks.

This should help to reduce the riskiness of bank activities and to make them more transparent to the regulators. But it won't be enough. It will still be possible to hold complex treasury instruments such as CDOs within a bank.

When the next crisis comes, it is unlikely to be over the same financial instruments which precipitated the last one. Stopping banks from succumbing to the same problem which caused the last disaster won't stop the next one.

That is where limits on the size of banks come in. I am sympathetic to this idea, but primarily for competitive rather than stability reasons. The stability case is that if the big banks were broken up then they would no longer be too big to fail. But suppose they all piled into the same risky assets? The fact there were so many of them would do nothing to reduce the risk to stability.

I suppose the presumption is that if there were lots of them then they wouldn't all make the same mistake. But I think this underestimates the tendency to herd behaviour in financial markets. And the task facing central banks and regulators of having to sort out umpteen small banks which are all overloaded with dodgy assets would be more difficult than dealing with just a few. This is the sense in which, in my view, splitting the banks into umpteen parts will be no substitute for enforcing higher capital and liquidity requirements.

But it would help on the issue of competition, which is fundamental to banks' profits and hence to bankers' pay. Why do banks make so much money? There are three answers: because they take inordinate risks which are not fully reflected in the calculation of profitability; because what they do is not properly competitive; and because they take advantage of inside knowledge, stemming from their involvement in umpteen related financial activities.

The first factor is addressed by both the proposed separation of risky activities and increased capital and liquidity requirements. But the other two have received insufficient attention. With regard to huge swathes of what investment banks do, competition is pathetic. M&A advice is a notoriously uncompetitive area. What's more, the financial crisis has made this, and other activities, even less competitive because the already thin ranks of the investment banks have been thinned out even more.

Should the business be done at all? Academic research convincingly shows that most hostile mergers destroy value. So why do they take place? Simple. They are seen to be in the interests of the corporate executives involved, who are pursuing size, either for its own sake, or because their own financial rewards are closely associated with it.

Obama needs to go much further. With regard to banks, for "opportunities for synergy and cross-fertilisation" read conflicts of interest. The most recent financial disaster before the current crisis, namely the dotcom boom, had conflicts of interest at its very root, as leading investment banks' researchers pushed the merits of dotcom stocks that they themselves believed to be rubbish. The result of that scandal was Wall Street fudge – internal and Chinese walls, more compliance officers and enforced contributions to fund independent research. But the structure remained.

It shouldn't. It is time to consider rescinding some of the reforms which abolished the separation between brokers and market-makers (jobbers) in the capital markets. In the UK this change came in 1986 as part of the so-called Big Bang which introduced competition into the financial system and paved the way for the entry of the American banks into London. There was much that was bad about the old system, including fixed commissions which were a sort of minimum wage for stockbrokers – at an exorbitant level. But the idea of separate functions was a good one. It meant that the brokers' focus was on the client.

So two cheers for the Obama proposals. They are a start. But the President needs to be much more radical. For all its apparent success, this is a seriously flawed industry. It needs fundamental restructuring.

Roger Bootle is managing director of Capital Economics and economic adviser to Deloitte.

Comments: 5

Good suggestions. Simon –just because something happened 20 years ago, you think that it is far-fetched to say that it still has an impact? You could do with some elementary history lessons. Buffett made some additional suggestions last week. He said that the most effective thing to change behaviour, in his opinion, would be to ensure that those in charge –Chief Execs- knew when they took the reigns that if the bank had to get a public financial bail out then they and their spouse would forefeit their entire net worth. What happens now is that they get huge salaries if they win, and huge salaries if they blow up to the tune of billions (e.g. Goodwin, Prince). In anybodies book that has got to be obscene, and they have got to be laughing (until they realise what they have done). What is Myners saying today? Who does he think he is belittling Obama's reforms? He says that any agreement must be global ––he sounds like one of the bankers. The US leads. It would be easy to follow and then it would effectively become global. I'd be careful with Myners. He looks like he might be edging back towards the seductions of financial chums. We have got to try to stop the inbuilt incentives that have accumulated that create an unjust money-worshipping culture rife with perpetuating inequality. It is in everyones interest no matter where they think their interests lie that this is done.

Dear Oz, Thatcher left office nearly twenty years ago. Blaming her for what has happened in the last couple of years is far-fetched to say the least. Your visceral hatred of the woman clearly renders you incapable of rational thought.

The silly thing is the actual bankers who get the big bonuses take no risk. It's not like they are using their own capital as an entrepuener. The only risk is if they mess up big time they might not have a job so fill your boots while you can.

Why do banks make so much money? Because they create money out of thin air and then charge interest on the money they lend to governments, corporations and individuals.

You have just admitted,at last, that Thatcher was responsible for the current mess - thankyou !