Financial reform debate begins with a familiar target: Goldman Sachs

As debate begins on the financial reform bill, one of the topics was the 'proprietary trading' highlighted in the Goldman Sachs hearings this week and called unethical by many lawmakers.

By , Staff writer

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    Sen. Jeff Merkley, (D) of Oregon at a news conference on Wall Street reform on April 21. He says the financial reform bill needs to be tougher on banks and Wall Street firms.
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The US Senate began debate on sweeping reforms to financial regulation Thursday, opening the door for possible changes that could make the bill tougher or looser before it goes to President Obama's desk.

A case in point is an issue that flared up in a separate Senate venue this week, involving the powerful investment bank Goldman Sachs.

At the Tuesday hearing, members of the Senate Permanent Subcommittee on Investigations peppered Goldman executives with questions, most of which boiled down to this: Is it appropriate for a financial firm to be betting against an investment with one arm, in its own trading, while marketing the same investments to clients with another?

To Sen. Carl Levin (D) of Michigan, the subcommittee chairman, the answer is no.

Goldman Sachs resisted his characterization that this amounts to a clear conflict of interest. Now, he and some colleagues are hoping to amend the Senate's financial reform bill to crack down harder on the so-called "proprietary trading" that firms like Goldman engage in.

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Plugging ethical gaps

An amendment he's proposing offers a window into the complex debates that could reshape the financial reform bill in coming days. The goal of the amendment is partly to plug perceived ethical gaps on Wall Street. But it's also intended to make the financial system safer, by reducing the risks that large financial firms take on in their effort to make profits.

Although much news coverage of the legislation has focused on debate over whether the current bill goes too far, this case exemplifies the other side of the coin. Many Senators believe the bill needs to become tougher on banks and Wall Street firms.

Sen. Jeff Merkley (D) of Oregon, a co-sponsor of the amendment, told a press briefing Thursday that he and Levin are starting to enlist support across party lines, and that some Republicans share his concerns about proprietary trading.

'Not liberal or conservative'

"This is not a liberal or conservative issue," Mr. Merkley said. "The integrity of the Wall Street system of allocating capital is a pro-business position."

Even if it may be pro-business, however, the idea must win its way into the bill.

The amendment would bar traditional banks and their parent companies – focused on deposit-taking and lending – from proprietary trading. It would also call on regulators to set tighter safety standards for non-banks that engage in such trading.

If an institution is large and "systemically important," like Goldman Sachs, it would need to set aside more capital as a cushion against the risks of its trading.

The measure also seeks to reduce conflicts of interest. "If you are designing securities and you are selling them, [you can't be] betting against them," Merkley said, adding that the Goldman hearing this week put that problem in a "spectacular spotlight."

At the hearing, Goldman executives repeatedly sought to distinguish their role as a "market maker," distributing investments to clients, from their trading activities. CEO Lloyd Blankfein and others said clients of Goldman as a market maker do not expect the firm to disclose its view of the securities' quality.

The firm also rejected the characterization that it had a massive bet that the housing market would crash in 2007, saying it had many "long" investments in mortgages that balanced against its "short" positions.

Many banks oppose a ban on proprietary trading, since trading in their own investment funds is an added profit source alongside their other activities.

Fixing 'too big to fail'

But some finance experts say the move could fix one of the key problems that emerged in the financial crisis: Firms that were "too big to fail" (important to the system) but that took on large trading bets and thus risked failure amid the 2008 climate of panic.

Here's the interesting twist: A ban on proprietary trading is already in the bill that Sen. Christopher Dodd (D) of Connecticut has brought to the Senate floor. But the ban, dubbed the "Volcker rule" after the former Federal Reserve chairman who supports it, would be implemented only after a regulatory study period. Supporters of the ban worry this creates leeway for the curbs to be watered down or dropped.

So a fight is shaping up. Where some Republicans want to weaken Dodd's existing Volcker rule, it's possible that the Volcker rule could remain unchanged. Or it could become stronger through the Levin-Merkley amendment.

If it does, Merkley says he expects Goldman would change its current charter as a bank holding company, so that it can continue proprietary trading. But the trading would still face new rules.

Related:

Goldman Sachs under fire: Is Wall Street cheering or cowering?

Goldman Sachs hearing pulls back curtain on bankers' ethics

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