One Step Forward, One Step Back

By / 1.22.2010

The White House yesterday announced new restrictions on banking activity, designed to address the issues that caused the crisis 15 months ago. Wall Street reacted by letting stocks fall 200 points, which initially would make you think the announcement must be right. The White House’s plan has two main parts: a limit on the scope of banking activity and a limit on the size of banks. One part makes sense, but as presented, the other should be re-thought.

Limit on Size – The good part is the limitation on the size of banks. This will include a tighter cap on the control of deposits. Currently no bank can control more than 10 percent of the nations deposits — but Bank of America got the Bush administration to waive that in 2007 to buy LaSalle. The administration’s proposal would have this cap include non-insured assets and other deposits. While this is a good first step, its effectiveness will be spelled out in the details. Bank of America is the only bank that exceeds the current cap, and almost 25 institutions could be considered “Too Big To Fail.”

Limit on Scope – At first blush, this seems to be a ban on banks taking FDIC-insured deposits – or having received TARP money – from engaging in proprietary trading. Prop trading is a major part of Wall Street activity, in which investment banks trade with “their own money.” That is, they engage in trading on their own behalf, not on the behalf of customers. The administration is right that a lot of this trading on prop desks is speculation. However, prop trading is also how investment banks and market makers engage in risk management and hedge positions. Banning prop trading by banks would severely curtail their market-making ability, and dry up liquidity on Wall Street faster than a sponge in the sun. Better than limiting the type of activity trading desks engage in would be to limit the amount of leverage they can use in that speculation.

The administration has said it is going to work with Congressional leaders in the coming weeks to spell this out in details. We’ll see if Congress is able to improve on these suggestions.