On January 21, US President Barack Obama shocked the financial markets by proposing rules that would prohibit commercial banks from making trades for their own accounts and prohibiting banks from owning or investing in hedge funds or equity funds.
"We should no longer allow banks to stray too far from their central mission of serving their customers," Obama said in a White House address.
The proposals were immediately dubbed the "Volcker Rule", a nod to the aggressive cutbacks advocated by former US Federal Reserve chairman Paul Volcker, and a sign of who Obama is listening to these days.
Volcker argues that limiting commercial banks from wading into investment banking would be in the spirit of the Glass-Steagall Act, the now defunct Great Depression era law that put a wall between commercial banks' investment banking operations and their deposits. Congress repealed Glass-Steagall in 1999.
The Volcker Rule -- which at this stage is murky on the details -- is not an exact replica of Glass-Steagall. It appears as if big banks would still be able to engage in flow business and make trades for the benefit of their clients; they just wouldn't be able to engage in such transactions for their own benefit.
Immediate impact
One thing was clear, however. The proposals were aimed at the nation's largest banks, including Bank of America Merrill Lynch, Citi, J.P. Morgan, Goldman Sachs, Morgan Stanley and Wells Fargo. Not surprisingly, shares of all those banks fell on the day of Obama's announcement. Banks in the US are under public scrutiny for their pay and bonuses, so going after the industry is an easy populist move, but given the lack of details, the proposal seems more like a PR initiative than a sound economic plan.
Indeed, the US president's threat to limit banks' proprietary trading and alternative fund ownership even managed to distract investors from Goldman Sachs's strong earnings report on January 21. The US firm made about 10% of its net revenues of $4.79 billion in the fourth quarter from investing its own money through its trading and principal investment division. A Hong Kong Goldman Sachs spokesman declined to comment on this story, saying: "We are reserving judgment/comment until we know what is actually going to be legislated".
Thus far, Obama has provided no information on how the restrictions would be applied, saying instead that he would leave the details to be determined by Congress as part of the passage of existing financial reform bills.
As Clifford Chance pointed out in a client memorandum: "It is difficult to predict whether these restrictions will make it into final financial reform legislation in their current form or whether they would even be a part of the final legislation. If they become part of the final legislation, it is likely that they will be watered down through compromise and it is also likely that some activities will be grandfathered. As with consideration of all of the proposals for regulatory reform, the next few months in Congress will be critical."
Other analysts are already noting that whatever Congress comes up with, the banks can likely circumvent. For example, Goldman Sachs could move its proprietary trading operations to the company's asset-management arm. Or it could simply sell off divisions, including its deposit-taking bank business, which would likely remove Goldman from the scope of the proposed legislation.
What one has to question is whether these proposed changes will do any good. It's unlikely that we would have avoided the financial meltdown of 2008 even if they were in place. Consider that it wasn't just big banks that got into trouble -- dozens of small banks you've likely never heard of also went down in the mess. However, one argument for the legislation is that it could prevent future problems; and that's hard to argue with.
Photo by AFP Photos.
