Obama and Volcker Must Go After the Big Banks
Thus far, President Obama’s financial reform strategy has reeked of political expediency—talk tough to Wall Street, act gentle, ride out the populist anti-banker tide, hope for the best, change nothing. But Obama may have awakened to the smell of one-term coffee after last week’s Massachusetts Senate race results. It's certainly heartening to see Obama eschewing the advice of Wall Street-placating Treasury Secretary Timothy Geithner for that of the sager, former Federal Reserve Chairman Paul Volcker. Nevertheless, demonstrating the serious financial reform behind the political fluff talk will take more than a stint of administrative realignment.
Big bank stocks tanked after Obama rolled out the new Volcker rule, and mainstream media headlines attributed the declines to investor concerns that the crazy days of unregulated bank trading will be coming to an end. But the President's actual proposals were not enough to seriously rattle anyone on Wall Street. If anything, the banks were fretting over the prospect of losing the tag-team of Geithner and Fed Chief Ben Bernanke, whose joint brainpower has showered $6.4 trillion in subsidies upon the industry.
Anxious about his own political survival, Geithner rushed to warn us that the markets would be in worse shape if Bernanke were pushed out, a proclamation that put bank stocks back on the ascent—hooray for the bailout-backers! Geithner has spent years working as a lackey for our biggest banks and knows he's got "fall guy" written all over him, so he's been covering his tracks of late. (We'll see just how well at today's AIG hearing before the House Oversight Committee.) He'll be going on the offensive until someone on his own team decides he's expendable. It would be nice if Obama figured that out and chucked Geithner out before he deals out any more damage.
The until-recently-sidelined Volcker is a better fit for popular opinion. He has both criticized the insane subsidies the government is funneling to the financial sector, and offered serious, concrete ways to reduce the risks reckless banks foist on the public. But Obama’s Volcker-inspired proposal falls far short of the full Glass-Steagall resurrection that is needed to truly stabilize the financial system (along with a handful of other smaller-bore regulations).
Glass-Steagall barred the combination of risky, high-flying investment banking with boring commercial lending—accepting deposits and making loans. But Volcker's ideas only take aim at a relatively small portion of the risks embedded in the investment banking business. As long as commercial lending and investment businesses remain intertwined under the same umbrella, financial behemoths will still be inclined to gamble their capital in securities trading rather than support the economy by lending to businesses and consumers. Given all the cheap money banks can currently get from the federal government, they have no obligation to do otherwise. When markets go up, securities trading is inherently more profitable, since, after all, the markets are up. For banks, the more trading they can do, the more easy profits they can score.
Volcker has always maintained that it would be difficult to explicitly break up the banks in a true Glass-Steagall sense. He has focused on ways to reduce their most obvious, unnecessary risk-taking activities and cut them off from some forms of taxpayer assistance in a bind. Yet Volcker would still allow boring commercial banks to perform securities underwriting, package mortgages into crazy securities and engage in risky asset lending—as long as these were "client-driven" activities.
What is "client-driven" trading? Well, it's the vast majority of what we ordinarily think of as risky trading activities.
These ideas represent the core of Obama's latest bank reform plan. Banks that accept federally guaranteed deposits wouldn’t be able to own, invest or sponsor hedge or private equity funds, nor could they run propriety trading operations (betting their own capital for the hell of it). There would be no limits on investment banks that don't accept deposits, no limits on independent hedge funds or private equity firms, and no return to Glass-Steagall.
The major problem with the Volcker rule is that it only bans "prop trading," when it should ban all trading at economically essential commercial banks. As it stands now, the plan would be a minor inconvenience to Goldman Sachs and Morgan Stanley; if they wanted to keep their hedge funds, they’d have to give up their Bank Holding Company status and their cheap loans from the Fed. My guess is they'll simply negotiate a grandfather clause and keep the BHC banner, but even if it were revoked, the Volcker plan is too little, too late. The Fed granted BHC status to Goldman and Morgan in the middle of the crisis to give them access to billions of dollars of government backing. Even if it's revoked now, we know it can be given back when another crisis hits.
Banning prop trading alone won't be enough to stabilize investment banks like Goldman Sachs, much less commercial banks that actually do something for the economy. Of all the bank holding companies, the only firm with any kind of remotely large-scale prop operation is Goldman Sachs, which CFO David Viniar said at last week’s earnings call is "a very, very small piece of what we do." Indeed, it amounts to about 10 percent of the firm’s total revenues. Total trading however, makes up 76 percent of its profits. That’s where the real risk is fermenting.
What's more, it’s impossible to tell just how much trading is uniquely proprietary and how much can be classified as client-driven. Proprietary trading isn’t even specifically broken out on most of the banks' filings, and where it is, it’s not an overriding factor.
Goldman garners a higher portion of revenues from trading than any other bank. Its 2009 revenues were $45.2 billion (it still enjoys generous various government support, including $12.9 billion from the AIG shell-game), with 76 percent or $34.4 billion coming from trading related business, compared to 41 percent or $9 billion in 2008, and 68 percent in 2007 and 2006. Only approximately 10 percent of its revenues come from what it lists as proprietary trading.
JPMorgan Chase and Morgan Stanley trade under investment banking division headings with negligible contributions from anything deemed proprietary. Yet JPMorgan Chase’s 2009 net profits shot up to $11.7 billion this year, more than twice its 2008 figures, bolstered by its trading activity. In 2009, Morgan Stanley’s trading revenue was 27 percent of total revenues, compared to a loss in 2008. By the third quarter of 2009, trading was the firm’s most profitable division. There's plenty of risk, but it isn't from strictly proprietary trading.
Bank of America has its fixed income, currency and commodities trading figures merged together, making it impossible to see the contribution of Merrill Lynch’s sizable trading activities, or the line between proprietary and client-driven trading. Its 2009 trading revenue was $15 billion, or 13 percent of total net revenue, up from a $6 billion loss the previous year and $7.2 billion, or 11 percent in 2007.
Citigroup, having led the banking industry in government support at $374 billion, saw its net revenues recover (up 65 percent in 2009 vs. 2008), as it made $21.4 billion in trading revenue, or 27 percent of net revenue compared to a loss of $22.1 billion in 2008. The firm breaks out its trading revenue figures to some extent, but alters classifications frequently. It has about a trillion dollars of transactions residing off balance sheet—risky as hell, but not considered proprietary.
So at all of the major financial conglomerates, trading activities that sparked major losses in the crash remains through the roof. And we don’t really know how much of it Volcker would crack down on.
We are kidding ourselves if we think banning proprietary trading or official hedge fund or private equity relationships will have a meaningful impact on our broken banking system. A new Glass-Steagall, by contrast, would force a true distinction between commercial banks with access to federal support and those that rely on trading and investment banking. It would detangle the risky Merrill Lynch enterprises from Bank of America, and expunge Bear Stearns and other investment bank subsidiaries from the books of JPMorgan Chase. It would remedy the Robert Rubin-Larry Summers-deregulation-spawned nightmare that is Citigroup.
Absent this clear separation, these too-big-to-fail firms will just call every trade they make "client-driven" and alter their technical financial distinctions accordingly. A proprietary trading ban is meaningless if everything risky is easily reclassified as client-driven trading. We can't limit something that isn't fully disclosed or can be easily camouflaged. If we don’t restrict all trading at bank holding companies by separating out the investment banking operations from the commercial banking business, we’ll be outdone by loopholes, and stay one step behind the banks on every move.
Volcker has the right idea, but Obama must take it much further if he wants to protect our economy from Wall Street excess.