Debate about the root cause of the financial crisis has raged for over a year. With blame to go around everywhere, there is no clear winner and many losers. Ill conceived government policies to stimulate single family home ownership, overly accommodative monetary policy, and explosive growth of a loosely regulated and poorly managed shadow banking system designed to disburse risk ….all helped fuel the crisis. Now that bank taxpayer bailout funds are being repaid and fears of a nationalized banking industry allayed (at least until the next “too big to fail” runs into trouble), what is an appropriate level of government involvement in the banking system?

Recent history suggests the key to creating a successful and healthy banking model lies in finding the optimal balance between free-market economics and government regulation. As this is more or less a zero-sum game, let us focus on the regulatory side of the equation. Two recent legislative initiatives could greatly re-shape the banking and financial services industry.

The Restoring American Financial Stability Act of 2009 proposed by Senator Christopher Dodd offers a number of alternatives to Barney Frank’s financial reform legislative agenda including:

• Consolidation of bank regulatory activities under one empowered organization,
• Significant reduction in FDIC and the Federal Reserve’s role in banking oversight,
• Government intervention to soften the market impact of “too big to fail” firms gone bad and
  

Separately, Senators Maria Cantwell and John McCain introduced bi-partisan legislation to effectively resurrect Glass-Steagall a decade after it was abolished. The Cantwell-McCain Legislation would generally:

• Prohibit commercial and investment banks from affiliating in any manner
• Require legal separation of officers, directors and employees
• Prevent commercial banks from engaging in insurance activities
• Create a one year transition period for compliance
  

If forced to choose (which of course we aren’t) the Cantwell-McCain proposal represents a good alternative. There are many who criticize the idea of creating a 21st Century Glass-Steagall Act on the grounds that it is outdated, and simply does not satisfy the needs of the modern financial system. The fundamental premise is that large global corporate clients have sophisticated financing needs that only a fully integrated (‘integrated’ meaning the full menu of commercial banking, investment banking and sales and trading products is offered under one umbrella) global financial organization can provide. Looking over the wreckage left behind from the recent financial crisis, it’s hard to see the wisdom in that argument. It seems the separation of federally insured bank deposits from risky trading and investment banking activities would strike the requisite balance between free-market capitalism and the heavy hand of government (the Dodd bill calls for the bail-out of “too big to fail” firms, up to a $4B ceiling). If the Cantwell-McCain legislation is passed, independent commercial and investment banks would be free (short of mandated max leverage ratios and/or higher risk based capital requirements) to individually pursue profit maximizing strategies, without the risk of robbing Peter to pay Paul.

So what is an appropriate level of government involvement in the banking industry? Surprisingly it may not need to be much more, or extremely complex. Simply separating those businesses with an implicit government backstop (and I am certainly not talking about any “too big to fail”) from capital raising and trading activities might be just enough.

A little better balance between the profit motive and public accountability might help as well. Greed is good. Opacity is unacceptable. Suicide is always to be prevented.

What do you think……..?

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Posted by Jaidev Iyer, MD, GARP at 11:54 AM 5 comments