Obama Switches from Wall Street to Main Street

Barack Obama changes his tune with his speech on bank regulation reform. Reversus [the article’s blogger] highlights the consequences of pursuing policies that pander to the electorate, which occurred shortly after the loss in Massachusetts.

A Change in Stance for Barack Obama

One does not blame U.S. politics for submitting under the pressure of Main Street to review banking regulations. Nevertheless, the measures announced last week call for us to analyze and consider them in an objective manner.

From a political point of view, Obama’s speech on Jan. 21 marked a shift in the influence of his economic advisers. Since the beginning of his term in office, Tim Geithner and Larry Summers served as the president’s close economic advisers. However, as these two men began to be seen as the defenders of Wall Street, their influence, along with their popularity, began to decline. Since then, Obama has been leaning on a different team — Paul Volcker and Austan Goolsbee. Volcker and Goolsbee have a markedly harsher attitude toward Wall Street, which is closer to the aspirations of Main Street. President Obama’s change of tone was a clear reflection of his break from Geithner and Summers.

Obama also took on an aggressive tone against the banks on Jan. 21 when he outlined the proposals for future reforms of banking regulations. While banking reform has been in talks for months, there is no doubt that it was seized upon with a new sense of urgency due to the Democrats’ loss in Massachusetts. Obama’s speech focused on two points: limiting the size of banks and prohibiting a bank’s riskiest transaction (involvement in hedge funds and private equity) in banks where the deposits are guaranteed by the government (a lighter version of the Glass-Steagall Act). In my opinion [the author’s], the proposed reform responds more to public sentiment rather than attacking the essential issues.

Yes, the banking sector would be more stable if its risky transactions were limited; however, three responses come to mind. Outlawing proprietary trading (done within commercial banks) would not prevent other institutions from leveraging risks that led to huge losses in the banking industry. The traders within commercial banks are not to blame; they are not the creators of these securities. Instead, they were created by banks like Morgan Stanley and Goldman Sachs, whose revenues depend strongly on these trading activities. It can be guaranteed that institutions like these will work hard to evade any sort of regulatory restrains. And the result would be the same. If Goldman were to go bankrupt, the U.S. government would surely step in. So, the question becomes how to distinguish those who make the market from those who trade its products. The lines that distinguish these degrees are very gray.

Likewise, limiting the size of the banks is an honorable objective, but it is insufficient. The debate on how to do this becomes very technical. What are we measuring and how are we measuring it? The size of assets? A bank’s own equity? Its profits? As Raghuram Rajan shows, banks possess the legal means to manipulate their balance sheets to their advantage. Furthermore, and more importantly, it is not evident that being a large entity is synonymous with being a systemic risk. Bear Stearns was relatively small, but it was deeply interconnected with the financial market, which forced the government to step in. What should be measured and what is important to measure is an institution’s concentration within the market and a correlation of its risks. Twenty small banks exposed to the same risk (the housing market, for example) are more dangerous than a single bank, equal in size to 20 small ones, whose investments are diversified.

If Obama does not carefully consider how to adequately reform the banking system, he risks offering forth a vision that is meant to please the electorate but that will translate into insufficient measures. Measures that will prove to be weak, perhaps out of scope, and, paradoxically, not strict enough.