Obama’s flailing bank reforms

Regulatory efforts guided by political expediency almost always turn out to be ineffective. The reasons are obvious. The rules will be designed to score the most political points, at the same time trying to avoid undue political risks. That will make the policy overhaul less ambitious and limit their scope. It is likely that the new regulatory reforms proposed for US banking industry will have the same fate.

Because of the peculiar way in which the political system in the US works, there will be as many proposals as there are power centres. The House of Representatives has already passed its version of banking regulatory reform. The Senate, the upper house, has been struggling with its version for a while now. Just when shifting political winds were making it difficult for the Senate to move forward, the Obama White House decided to barge in with a few additions of its own.

Among Obama's new proposals, the Volcker Rule, named after the former US Fed chairman Paul Volcker who has always been a strong advocate of heavy bank regulation, will prevent banks from undertaking any kind of trading investments by risking their own capital. That includes all kinds of proprietary trading and bank ownership of private equity funds and hedge funds. If the proposals become law, banks which are now active in these businesses will have to either discontinue them or give up their bank status.

Volcker starts from the premise that banks protected by government deposit guarantees should not have the luxury of trading or speculating with their own capital.

Fair enough. If a commercial bank suffers heavy losses from proprietary trading and its survival is in question, the depositors have to be protected. The deposit insurance agency, or the central bank in some countries like India, will seize the bank and settle the claims of depositors. The business is either allowed to fail or transferred to buyers, if there are any.

But, if the bank is too large and systemically important, the government cannot allow it to fail because that could trigger a chain reaction across the financial system and hurt the economy. Every bank bailout by the government is triggered by this fear. By removing the so called riskier activities from the banking business model, the Volcker Rule aims to eliminate the need for a bailout.