In the wake of the biggest financial meltdown since the Great Depression, it has become clear that allowing banks to engage in reckless market trading and, at the same time, to become too big to fail has itself failed as a public policy. The behemoth banks that stretched the limits of casino trading on Wall Street and global capital markets, and then had to turn to Washington for emergency capital when the bubble burst, exposed both the frailty and venality of even the largest banks. President Obama’s proposal last week to restore Glass-Steagall-style regulation on the size and scope of banks and to ban their risky market trading marks a welcome return to regulatory sanity.
The president’s new proposals, advocated by former Federal Reserve chairman Paul Volcker and a range of economists, would reset well-founded regulatory principles. It also would reconstitute a conceptual framework for the regulatory overhaul for banking with which the House and Senate have been struggling the past year.
Equally important, it would demonstrate to American citizens and ordinary investors and savers, and to a watching world, that Washington is able and willing to fix limits on big banks’ market trading. Such reform would help insulate the general economy and the strength of the dollar from the excessive risk-taking that marked the 2008 financial crisis and that threw the world into deep recession — and near-depression in many smaller countries.
Under the proposed rules, the government would put limits on the size of banks, and prohibit commercial banks — banks which take and lend investors’ deposits — from trading from their own accounts, a type of trading known as proprietary trading which puts banks’ capital and investors’ money at risk.
Size limits would be effected by regulatory mechanisms on large banks’ capital requirements and acquisitions, and would apply mainly to the nation’s 50 largest banks. The ban on commercial banks’ market trading would restore the line between regular commercial banks, which would still qualify for FDIC deposit insurance, and what used to be known as investment houses before the Glass-Steagall Act was revoked in 1999.
Revocation of Glass-Steagall protections, erected after the 1929 banking crisis that precipitated the Great Depression, allowed investment houses to act like banks, and allowed commercial banks with FDIC protection to proceed with proprietary trading in stock and capital markets that risked the deposits of ordinary savers and commercial clients.
The goal of reining in banks, as the widely esteemed Mr. Volcker put it, is to define and separate “who we (the federal government) are going to save and who were are not going to save. And I don’t want to save what is not at the heart of commercial banking.”
The proposed reform should be appreciated by ordinary citizens and Main Street. Neither like the bailouts that Washington was obliged to undertake to prevent a bona fide depression. Potential borrowers, as well, would benefit from redefining the line again between commercial banks and non-FDIC investment houses, where investors know they are putting their money at risk in dicey hedge funds and derivatives.
There should be a bright line between investment and commercial banks. If managers of pension and retirement funds decide to gamble with pension funds and churches’ investments, they’ll know the Fed is not going to make them whole if their market gambles tank. Credit rating agencies will be more alert to the quality of investments, as well.
And commercial banks would have to restore their focus meeting the credit needs of Main Street and mortgage borrowers — sectors that are now being ignored by banks that are once again focused on making gains in the capital and stock markets.
Congress, of course, still must convert the new banking proposals into law. Lawmakers will have to deal with Republican die-hards who continue, even in the wake of the meltdown, to resist restoration of essential regulations. That’s a battle that merits broad support.