Obama moves to cut big banks down to size

In a continuing effort to reform nation’s big financial institutions, President Obama Thursday proposed new rules to limit the size of these institutions and to prevent them from trading for their own accounts instead of for their customers.

Mr. Obama characterized his efforts as one more way to prevent another financial crisis caused by banks that are considered “too big to fail.”

The latest plan follows last week’s proposal to levy a new tax on the major banks to pay for the $117 billion in losses through the federal government's Troubled Asset Relief Program (TARP), which bailed out the banks and other companies. In a briefing with reporters Thursday, a senior White House official said the President intended to add his new proposals to financial reform legislation that has already passed the US House but not the US Senate.

The President indicated Thursday that he is angry over the banks reporting large profits and handing out significant bonuses after receiving billions of taxpayer dollars to help them through the financial crisis.

“My resolve to reform the system is only strengthened when I see a return to old practices at some of the very firms fighting reform,” said Obama, referring to “soaring profits and obscene bonuses.”

New restrictions

Obama's proposal would prevent commercial banks from owning, investing in, or even advising hedge funds and private equity funds. Hedge funds deal with sophisticated investors to try to find ways to profit in the markets. Private equity funds invest in businesses that are usually not traded on a stock exchange. Obama also wants to eliminate the ability of the banks to trade for their own accounts – for their own profits – rather than for their customers. The Obama administration considers that practice to be risky.

If passed, these prohibitions could crimp the profits of companies such as Goldman Sachs, which has said that it sometimes trades for its own account.

On Thursday, Goldman Sachs reported 2009 earnings of $13.4 billion and a compensation pool of $16.2 billion. Despite the higher-than-expected earnings, Goldman’s stock fell 6.92 points on Thursday following news of the proposed regulatory measures.

The fall in Goldman stocks was mirrored by other financial companies and the stock market as a whole. The markets rallied slightly in the afternoon after Rep. Barney Frank (D) of Massachusetts, chair of the House Financial Services Committee, told CNBC that he would be inclined to give the banks three to five years to spin off their assets. The Dow Jones industrial average tumbled 213.7 points, closing Thursday at 10,389.88 points.

Populist anger

Obama’s pique reflects public indignation. Banks, faced with mounting losses on their credit cards, have hiked credit card interest rates and fees and tightened standards. Many of those changes took place as Congress was passing more consumer-friendly credit card legislation.

“Politically, there is no harm in showing you are angry with the banks,” says Douglas Elliott, a fellow at the Brookings Institution and a former banker.

The new proposals, along with other pending financial reform, have the potential to completely change the banking system, analysts says.

“Most of the things that will be different are not readily observable, they have to do with the safety and profitability of the banks,” Mr. Elliott says.

Hard to enforce?

Banning banks from trading for their own account has potentially huge ramifications, Elliot says, since banks do a large amount of investment. “Maybe 30 percent of their assets are investments,” Elliott says. “How do you tell the difference between those investments and proprietary investments?”

The separation of “trading desks” and “investment desks” at these banks are mainly a matter of convenience, Elliott adds. “If there were no trading desks, they [would] have the same people do most of the functions of the trading desk on the normal investment desks. How do you draw the line?”

The proposal to limit the size of banks’ liabilities may also be difficult to enforce. Prior to the financial collapse, there were limits on the amount of deposits any single bank could hold. But as huge banks such as Washington Mutual began to fail in 2008, the Federal Reserve waived those regulations to allow the failing banks to be acquired.

The Financial Services Roundtable, which represents 100 of the largest financial services companies, issued a statement Thursday saying it supported Obama’s goals and efforts to strengthen the financial system. But it added, “The proposal will restrict lending, increase risk, decrease stability in the system, and limit our ability to help create jobs.”

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