Obama backs Volcker regulatory plan in dramatic about face

Today President Obama is set to propose wide-ranging moves on bank regulation first proposed by his economic advisor Paul Volcker, the former Federal Reserve Chairman. Details of the proposal have yet to be released. However, the focus is expected to center on strict bank size limits and a limitation on proprietary trading at regulated banks with access to the Fed discount window. This is a dramatic re-alignment in policy away from the no-strings attached bailouts backed by Geithner and Summers last year toward much more substantive financial reform. Sources close to the White House are saying that Volcker is behind this move.

As for the politics of this, we will need to see the details to understand whether this is a workable proposal which can pass Congress. Apparently, Obama does realize that the election result in Massachusetts was a rebuke of his financial reform policy of the last year that has put pressure on Congressional Democrats in the upcoming mid-term elections. The word around Washington is that the Democrats are desperate to demonstrate their anti-bank mettle in the lead up to November 2010 and want to see something which allows them to tap into anti-bank fervor among likely voters. While the recent bank tax proposal was a start, many – including me – have lambasted it as a political stunt; and that is unlikely to win over voters.

Below are a few quotes from the financial media on this turn of events.

The New York Times:

The president, for the first time, will throw his weight behind an approach long championed by Paul A. Volcker, former chairman of the Federal Reserve and an adviser to the Obama administration. The proposal will put limits on bank size and prohibit commercial banks from trading for their own accounts — known as proprietary trading…

Mr. Volcker flew to Washington for the announcement on Thursday. His chief goal has been to prohibit proprietary trading of financial securities, including mortgage-backed securities, by commercial banks using deposits in their commercial banking sectors. Big losses in the trading of those securities precipitated the credit crisis in 2008 and the federal bailout.

The president will speak at an appearance on Thursday at the White House with Treasury Secretary Timothy F. Geithner, an administration official said, speaking on the condition of anonymity because the talks were private. It will come after a meeting with Mr. Volcker.

Bloomberg:

“We’ve got a financial regulatory system that is completely inadequate to control the excessive risks and irresponsible behavior of financial players all around the world,” Obama said in an interview with ABC News yesterday.

“People are angry and they’re frustrated,” Obama told ABC. “From their perspective, the only thing that happens is that we bail out the banks.”

Voter anger helped Republican Scott Brown win the late Edward Kennedy’s U.S. Senate seat in Massachusetts this week, giving Republicans the ability to block Obama’s top legislative priority, a health-care overhaul. The Massachusetts seat had been held by Democrats for more than 50 years.

Reuters:

The Obama official did not provide details of the plan, which would require congressional approval. But U.S. lawmakers are already reviewing measures that, in some cases, recall the scope of financial reform enacted after the Great Depression.

Democratic Senator Jeff Merkley told Reuters earlier this week that there should be a firewall to separate risky trading activities and normal bank-lending.

A more aggressive proposal was put forth last month by former Republican presidential nominee John McCain and Democratic Senator Maria Cantwell. Their measure would reinstate the 1930s-era Glass-Steagall limits on banking by barring large banks from affiliating with securities firms and being in the insurance business.

Passage of the Cantwell-McCain bill would force firms at the center of last year’s financial crisis — such as Goldman Sachs, Morgan Stanley, Citigroup, JPMorgan Chase and Wells Fargo — to rethink their banking, investment and insurance operations.

An announcement is expected at 1140AM EST. Let’s see how markets and bank shares react both before and after this announcement.

As I see it, a key is structural reform i.e no sunsetting of reform legislation or targeting of specific institutions as we saw in the bank tax proposal. What is needed is a comprehensive industry-wide piece of legislation that says “if you want access to the Fed window, these are the limitations we now impose.” For example, banks with fed window access should not be hedge funds – which Goldman effectively is.

Further, the limit on size and leverage is also key. It is the leverage which did in the big banks. And this is not just in the U.S. Look at RBS as a prime example of excess leverage bringing a large institution to its knees. Many of the articles on this development acknowledge similar measures are likely to be taken in the U.K. as well.

Finally, Glass-Steagall is dead. We shouldn’t look to bring it back. Bear Stearns and Lehman were not commercial banks and so their bust had absolutely nothing to do with Glass-Steagall. Those looking to a reinstatement of this 1934 legislation as a silver bullet are living in the past.

This is just a first salvo. Other issues to be settled more comprehensively include a comprehensive bank resolution process, OTC derivatives, securitization, consumer protection, anti-trust violations, and criminal prosecution of fraud.

As for Volcker, the New York Times reports his saying:

The heart of my argument is who we are going to save and who we are not going to save. And I don’t want to save what is not at the heart of commercial banking.

This is exactly right. The commercial banking function is what is at the heart of our economy. All the rest is peripheral. Paul Volcker was right that he would “eventually” get his way. His persuasiveness is increasing.