Corporate Governance

Shock and Awe: From Massachusetts to the Obama ?Volcker Rule? (Part 4 of 10)

By Jennifer S. Taub

Early in the morning of January 21, news appeared that President Obama was prepared to announce a plan to get tough on the banks. At a press conference in the late morning, the President announced his plan, known as the "Volcker Rule."

Battle in the White House:
According to my around-the-Capitol sources, the President named his approach after economic adviser and former Federal Reserve Chair, Paul Volcker after a fierce debate in the White House. The winners included Paul Volcker and Vice President Joe Biden. The losers included Lawrence Summers (former Treasury Secretary and current Director of President Obama's National Economic Council) and Tim Geithner (current Treasury Secretary). As per many news sources leading up to the announcement, Paul Volcker has been advocating that we break up the too-big-to-fail banks. Many on both ends of the political spectrum agree with Volcker. Consider the ultra-conservative Wall Street Journal editorial page's endorsement of breaking up the banks, as well as progressive thinkers.

Causes of the Economic Crisis and the Bailout Remembered
 Frustrated that Wall Street was 'still operating under the same rules that led to its near collapse,' President Obama remembered the causes of the crisis.

'This economic crisis began as a financial crisis, when banks and financial institutions took huge, reckless risks in pursuit of quick profits and massive bonuses.  When the dust settled, and this binge of irresponsibility was over, several of the world's oldest and largest financial institutions had collapsed, or were on the verge of doing so.  Markets plummeted, credit dried up, and jobs were vanishing by the hundreds of thousands each month. We were on the precipice of a second Great Depression. "

"To avoid this calamity, the American people -- who were already struggling in their own right -- were forced to rescue financial firms facing crises largely of their own creation.  And that rescue, undertaken by the previous administration, was deeply offensive but it was a necessary thing to do, and it succeeded in stabilizing the financial system and helping to avert that depression.'

The Volcker Rule itself (as explained in his speech):

'Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers.  If financial firms want to trade for profit, that's something they're free to do.  Indeed, doing so –- responsibly –- is a good thing for the markets and the economy.  But these firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people."

"In addition, as part of our efforts to protect against future crises, I'm also proposing that we prevent the further consolidation of our financial system.  There has long been a deposit cap in place to guard against too much risk being concentrated in a single bank.  The same principle should apply to wider forms of funding employed by large financial institutions in today's economy.  The American people will not be served by a financial system that comprises just a few massive firms.  That's not good for consumers; it's not good for the economy.' (emphasis added)

Limiting Access to Cheap Money Through the Federal Reserve Discount Window

The President also addressed blocking non-depository institutions from access to cheap money through the Federal Reserve:  'Our government provides deposit insurance and other safeguards and guarantees to firms that operate banks.  We do so because a stable and reliable banking system promotes sustained growth, and because we learned how dangerous the failure of that system can be during the Great Depression. 

"But these privileges were not created to bestow banks operating hedge funds or private equity funds with an unfair advantage.  When banks benefit from the safety net that taxpayers provide –- which includes lower-cost capital –- it is not appropriate for them to turn around and use that cheap money to trade for profit.  And that is especially true when this kind of trading often puts banks in direct conflict with their customers' interests."

"The fact is, these kinds of trading operations can create enormous and costly risks, endangering the entire bank if things go wrong.  We simply cannot accept a system in which hedge funds or private equity firms inside banks can place huge, risky bets that are subsidized by taxpayers and that could pose a conflict of interest.  And we cannot accept a system in which shareholders make money on these operations if the bank wins but taxpayers foot the bill if the bank loses.'

Full post as published by The Race to the Bottom on January 28, 2010 (boomark / email).