Obama Going at Big Banks? For Real?

The New York Times reports this morning that President Obama will announce a new push today for new limits on the size of banks and new prohibitions on their ability to conduct proprietary trading.

The politics of this are obvious enough: after the Massachusetts disaster, which has dealt a major blow to the prospects for passing even a weak health care reform, Obama is reaching for something — anything! — to change the subject. With the big bailed-out banks reporting hefty profits and ginormous bonuses this week, at the same time that they fight off regulation and a modest new tax, what better time than this to bash the banks.

At this writing, we don’t know any details about what Obama will propose. They appear to echo ideas that Paul Volcker, the former Fed chairman, has been pushing in vain at least a year now.

Despite the whiff of desperation and cynicism surrounding this new push, the White House has good reasons to get tougher with the big banks.

The financial industry has been shameless about taking bailouts without taking responsibility for the reckless lending that gave us the crisis of the century. The banks have spent millions fighting the proposed Consumer Financial Protection Agency, even though outrageous mortgages were at the heart of of the meltdown. They have managed to dilute House legislation that would require financial derivatives to be traded on exchanges or through clearing houses (because, Lordy, that would force them to put up margin payments to secure the trades). And they got House lawmakers to limit the ability of state regulators to impose tougher rules than the Feds (recall that Federal regulators fought all the way to the Supreme Court to prevent states like New York and North Carolina from getting out in front on abusive mortgages).

We shouldn’t use regulation as a form of punishment or for pandering to populist fury on both the right and the left. But there are good reasons to limit the size and operational range of financial institutions.

Thus far, none of the bills to overhaul financial regulation would do much to prevent the rise of institutions that are “too big to fail.” Their main thrust would be to increase oversight of “systemic risk,” to promote higher capital requirements for TBTF institutions and to create an orderly way of winding them down when they fail.

My own belief is that the most important and valuable way to prevent TBTF, and the recklessness encouraged by the implied government bailouts, would be to make capital requirements so high for the systemic institutions that banks and Wall Street firms keep themselves smaller and simpler on their own. Capital requirements are at the heart of the whole story here, but they are so complex and difficult for outsiders to understand that regulators are always at risk of becoming captives to the industry.

In any case, as experts like Simon Johnson have long complained, it’s far from clear that the Fed or the Obama administration are pushing for really tough capital requirements anyway.

Imposing some kind of flat size limit on banks might be simplistic and a little ham-handed. It’s not just size that poses risks to the financial system. A well-placed hedge fund (e.g. Long Term Capital) or the division of an insurance company (AIG Financial Products) can do a lot of damage by virtue of its leverage and interconnectedness.

But perhaps it’s time to recognize the limits of regulators, no matter how diligent and sophisticated they try to be. If you can’t truly keep on top of a complex industry that changes constantly, maybe the wiser course is just to limit what the individual players can do.

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