Obama and Wall Street: Reforms need a closer look

Even before his State of the Union address, the president’s big reform is a tougher stance on banks. But can regulators really keep banks small by assessing risk?

President Obama spent much of his first year in office saving Wall Street from collapse. Now for his second year, he wants to save Wall Street from repeating history.

Mr. Obama didn’t wait until his State of the Union address this Wednesday to announce his toughest bank reforms yet. The Jan. 19 Senate election of Republican Scott Brown in Massachusetts – which may have reflected public anger at federal bailouts of financial institutions – may have forced his hand. So last Thursday, he surprised many with a proposal to limit the scope and size of big banks that rely on federal backstops.

Obama’s new ideas go far beyond his previous moves, such as reining in outsized bonuses and planning a tax on banks to pay for the bailouts. If accepted by Congress, they would fundamentally define the level of risk-taking in many of America’s capital markets. 

Obama’s tougher stance against Wall Street was a surprise to Congress. The House already passed its own less-drastic reforms last month while the Senate Banking Committee was well along in designing a bill in a bipartisan effort. 

By taking an even harder position, the White House move could easily be seen as more politics than policy. Running against Wall Street in this fall’s congressional elections could prevent a big loss of seats for Democrats – assuming Republicans defend Wall Street. Blaming others, especially bankers, is an old populist campaign trick.

Just the same, Obama’s reform ideas deserve a serious look. Never again should taxpayers need to rescue Wall Street to the tune of trillions of dollars or let its mistakes trigger a long, deep recession.

The main reform would limit the total liabilities that any one bank could take on. In theory, having smaller banks in the US would make it less likely that a collapse of one of them would pose a risk to the entire financial system, requiring federal intervention.

But Congress must ask how regulators can define such an upper limit in risk. And what is meant by “too big to fail”? 

Such a difficult analysis of each bank would require a much higher level of training and experience for regulators. And is this a better alternative than simply raising the level of assets that a bank must keep in reserve for potential losses?

A second proposal would bar banks from owning or investing in hedge funds and private equity funds. And they also couldn’t use their own money for investments, only their customers’ money. These steps would revive the kind of walls between bank functions that were put in place during the Depression but removed during the 1990s. 

But again Congress needs to ask if such reforms would get to the root cause of the 2008 financial crisis, namely America’s casinolike gamble on ever-rising housing prices and all the federal props for this industry, from Fannie Mae to the tax deduction for mortgage interest.

A main reason that banks got in trouble is that current federal regulations pushed them into investments related to real estate. The banks’ overreliance on property for assets and a belief that taxpayers would save the housing industry led to unrealistic assumptions of risk.

Before Congress takes up Obama’s reform ideas – or overreacts to public anger – it needs to ask the hard questions about the real origins of the financial crisis. And it also must look at the feasibility of regulators defining risk.

In addition, it must be wary of so hamstringing Wall Street for domestic purposes that US financial institutions don’t simply move to Europe or Asia. A global effort at reform is required for what is now a global industry.

Saving Wall Street from a repeat near-miss collapse will require a fine-tuned review by lawmakers.

of stories this month > Get unlimited stories
You've read  of  free articles. Subscribe to continue.

Unlimited digital access $11/month.

Get unlimited Monitor journalism.