At this year’s World Economic Forum in Davos, there appeared a seeming harmony—peoples’ uncertainty about regulation, about financial markets and about the economy—amidst larger divisions: keeping in view the asymmetric risks, one group felt that it is undesirable to reduce economic stimulus too soon; another group felt like giving a boost to the market confidence, at least in countries such as China which are not effected by meltdown, by cutting down stimulus and raising taxes; some have aired a veiled threat of more protectionism to counter the threat of global imbalances; yet another group that included Strauss-Kahn, Managing Director of IMF and Alistair Darling, Chancellor of the UK called for rapid progress in finding international agreement on bank reforms, while a few countries are unilaterally going ahead with contradictory regulatory moves dictated by the respective local politics.
Amidst these diverse concerns, what has emerged as the most urgent is the creation of a better regulatory mechanism of global financial system, for financial crises, as Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University have argued, are ‘an equal opportunity menace’—even the most sophisticated financial system of a country is vulnerable to such a contagion.
In pursuant to his stated objective—“Never again will the American taxpayer be held hostage by a bank that is too big to fail”—Barack Obama announced his plans in late January to bring forth regulatory reforms: “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.” It is however clarified that banks would be permitted underwriting of securities and market making.
Unsurprisingly, the Wall Street firms, including Goldman Sachs, whose culture is almost dubbed to be that of a ‘proprietary nature’, are against this measure for it prohibits them from playing in capital markets to quench their thirst for profits with ‘insured’ deposits. This resistance is, of course, understandable, for it takes them back to the days of the Glass-Steagall Act—Depression-era law that separated commercial banking from investment banking—by virtue of which their profits are feared to be cut manifold.
Nevertheless, banning of trading in capital markets by commercial banks, along with prohibiting them from underwriting securities and market making, is advisable, for it eliminates concentration of too much risk at a single place. And the more the diffusion of risk over a wider area, the less is the scope for banks’ failure.
Against this backdrop, what is most surprising is the resistance from international regulators. It was mostly the Europeans, who, perceiving it as a unilateral move that undermines the earlier understanding to cooperate with other countries through G 20, the Financial Stability Board, and the Basel Committee on Banking Supervision, vociferously opposed Obama’s proposal at Davos. Similar hostility was also aired by major European banks such as Deutsche Bank, Barclay’s and Société Générale. They are, instead, proposing higher capital charges against the ‘trading position’. The mute question would however, be: How much capital is safe enough to keep banks safe, should a calamity like the one we witnessed in 2008 recur?
There could however be ‘unintended consequences’ flowing out of Obama’s proposal: one, we cannot have a system-driven reform, if each country implements what it needs for itself; two, as the banks withdraw from capital markets, they may become less liquid; and three, proprietary traders may shift to hedge funds making them much bigger enhancing their systemic-risk, warranting close watch for averting any future crisis.
The revelation from all these arguments is that capital, like water, can flow around the obstacles toward profits and hence politicians must be wise enough to bring such reforms that would not create new risks.
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