Obama Adopts Volcker's Solution: If Banks Want Govt. Guarantees, They Have to Close Their Casino Operations

The news that President Barack Obama is finally listening to Paul Volcker is welcome, but the specifics of Obama's big bank crackdown are not as positive as initial reports had indicated.

For more than a year now, Volcker has been urging policymakers to deliver strong regulatory medicine to revive the weak U.S. financial system. But Obama and other top advisers like Larry Summers and Timothy Geithner have resisted the former Federal Reserve Chairman's overtures, instead opting for a set of small-bore, technocratic tweaks to a system that is fundamentally broken. (There's one major exception to this pattern—Obama's proposal to create a Consumer Financial Protection Agency is a dramatic and critical step for salvaging the American economy, and the President has advocated for it over Geithner's objections.) Volcker has repeatedly suggested that banks that are too-big-to-fail are simply too-big-to-exist, and has consistently and correctly urged that banks be banned from participating in risky, high-flying securities trading. Today, Obama acknowledged these were good ideas.

Commercial banks are the backbone of the U.S. financial system. They accept deposits from consumers—your paychecks—and they make loans that keep businesses humming. Commercial banking is the way people and companies pay each other for goods and services. Without commercial banks, there is literally no economy and all hell breaks loose. To help protect against this economic Armageddon, the U.S. government guarantees bank deposits to ensure that our paychecks won't simply disappear if a bank fails. But since the repeal of the Glass-Steagall Act in 1999, banks have increasingly become involved in risky gambling activities in the capital markets, and they've made their bets with the deposits the government guarantees.

That's crazy. So Volcker has a simple solution: if you want to accept government-guaranteed deposits, you can't attach a casino to your bank. Obama endorsed this plan today, and it is truly an extraordinary step forward for economic policy. It would require banks to either end these risky activities, or sell off the portions of their business that engage in it, forcing too-big-to-fail banks to downsize their operations.

But even if you ban this so-called proprietary trading, we would still have banks that are too-big-to-fail. There is a well-established regulatory plan for dealing with failing commercial banks: let them fail and save the deposits. But when Wachovia went down in the fall of 2008, regulators didn't follow the plan. Instead, they intervened to orchestrate a merger with Wells Fargo. The worthless, failed Wachovia bank was acquired by Wells Fargo for $7 a share, a deal that amounted to a federal subsidy for Wachovia's shareholders. Wachovia was simply too big to go down without ravaging the economy. So even if we ban proprietary trading at commercial banks, many U.S. banks would remain too-big-to-fail.

And Wachovia was a relatively easy bailout—Citigroup and Bank of America needed much bigger, repeated bailouts. If the problem is oversized banks, breaking them up is the only way to solve it. Here, Obama seems to have dropped the ball. While Obama would impose a hard cap on bank size, he implied in his speech that this cap would not prohibit the multi-trillion-dollar behemoths that currently exist. From his address today:

"As part of our efforts to protect against future crises, I'm also proposing that we prevent the further consolidation of our financial system," Obama said.

Nothing to see here, folks, just a handful of megabanks that the government handed out trillions of dollars to save. (Yes, trillions—the bailout operations were much broader than the $700 billion Troubled Asset Relief Program.) That timidity was emphasized on a conference call that senior administration officials held with reporters.