Well, that at least is my initial take on a subject that ought to be dominating economic policymaking in the next few weeks: what to make of his banking reforms, described by the FT as a declaration of war on Wall Street. They must be pretty full-on, if even Baseline Scenario seems to approve.
I have not had a real chance to go over all the proposals. But the idea of not letting banks own hedge funds and private equity seems to have some merit. Some people argue that in creating and selling on securitized instruments and derivatives (RMBS’s, CDO’s, etc) the banks were left with insufficient ‘skin in the game’. Surely, on some important level, this was nonsense. They were flayed alive, losing $ trillions: that is a lot of skin.
The textbook model for how securitization was meant to help improve financial stability imagines the banks as intermediaries, and the end users of these products being the entities with lots of capital and the right attitude to risk to take them on. So, insurance and pension funds, for the less risky tranches; hedge funds and so forth for the riskier bits. The Banks – with their essential role in intermediation, maturity transformation and transaction-handling – are then left much more immune to a fall in those asset prices. Their assets are now liquid, unlike Banking 101 when they hold a bunch of mostly local, bespoke and untradeable loans to people for 20 years.
This model, beloved of Greenspan when he said financial innovation had made the system more robust, was not put in place. Instead, the banks ended up holding on their trading books all or most of the nasty bits. Or they sort-of owned hedge funds that did this, off-balance sheet, but with enough of a real or presumed obligation to stand behind them that when they went sour the risk belonged to the banks.
This was a banking crisis, not a financial market crisis. If it had manifested itself through the collapse of non-banking assets held somewhere else – like, for the most part, the dot com crash – it would have had nothing like the same serious implications.
So stopping the banks having this dual role makes quite a lot of sense, on this interpretation. Whether they can make the separation without massive unintended consequences is another thing – particularly if, as EoC observes, this is driven by short-term politics. How will the market making be distinguished from the position taking, for example? (see same link). Will this mean a sudden loss of liquidity on exchanges? The FT (see that link) suggests a move towards hedge funds instead:
However, some believe that would not last long, as traders regrouped outside banks and set up their own “prop shops”. Christian Katz, chief executive of SIX Swiss Exchange, and a former Goldman Sachs banker, says: “The net effect, longer term, could be neutral; it doesn’t have to be a collapse.” However, any immediate exit could benefit hedge funds and independently operated proprietary trading firms – including “high-frequency” trading firms.
The immediate conclusion from Obama choosing this route is that he prefers the hedge fund model to banks. He has a good reason to: hedge funds are less leveraged, can collapse without systemic implications, and in fact do collapse; can allow private investors to share the extraordinary high returns that from time to time occur; and have a better aligned compensation model. They also offer the sort of competition to banks that may drive down some of their oligopolistically high profits (see Philip Stephens). What is not to like?
IN OTHER NEWS. My hunch about the popularity of MyDavidCameron was right: it is more popular than griping Guido. Now that I am no longer linked to (fair enough: I am not as rabidly anti-Tory as most of its albeit very funny content), I can discover just how few mates I have