Obama and the banks

Mr Obama, perceived in America as having been too close to Wall St, has suddenly moved in the opposite direction. Middle America was confused and angry about the billion dollar bail outs and fabulous headline salaries (rather than the average wage bill in financial services but that is another matter). Obama, in trouble over healthcare, is making a leap towards the middle classes. This is political, but there again most things are.

I posted in March last year about what used to be known as the Glass Steagall Act (GSA), separating commercial banks from investment banks, so that a financial institution either deals for the customer or for itself but not both.

The points against GSA, and these will come out strongly as the financial sector lobbyists swing into action over the next few weeks, are valid: inhibiting the free flow of money will reduce the efficiency of the markets and will ultimately be against the interests of the consumer. We have benefited greatly from the loosely regulated markets, right up to the time they went belly up.

But I am broadly in favour of GSA. The legislation, in place since the thirties, was cancelled by Bill Clinton at a time when we didn’t think the markets could possibly crash in the way they in fact did. Now we know differently, we have to consider this implied contract: we know deep down that we can’t let major banks go bust because the whole edifice would come down round our ears. The Central Bank is clearly an insurance for them and they must therefore suffer detailed regulation and mitigate all possible losses, as you have to in any insurance contract.

GSA was clumsy and we don’t yet know the details of Obama’s plans. But it should be possible to allow the banks to operate in the casino but ring fence the capital for the bits we can't afford to go under. A holding company would own an investment bank and a commercial bank, capitalising both. The investment bank could make its losses and go under but could not use the capital of the commercial bank, dragging it down too. There would be no guarantees between the two. The commercial bank, in return for operating in a safe environment, would be subject to closer regulation and not allowed to play in the casino. An advantage of this is that as we understand more about the financial instruments that are being created we could allow them, simply adding them to the list of what is permitted to the commercial banks.

The advantage of this method is that it accepts that, with the ceaseless development of new products in the investment banking scenario, the regulators can’t keep up. Some investment banks will go bust, but they won’t take us down with them.