US Banking Reforms – An All or Nothing Proposition

US President Barack Obama yesterday introduced a series of proposals that would limit the size of US banks and prevent them from engaging directly in some of their most profitable lines of business. The highlights of the regulations should they be approved and adopted, would place a limit on the total size for each bank, proportionate to their position in the overall market. In addition, banks would be prohibited from operating or investing in a hedge fund or private equity fund. The proposals also call for an end to proprietary – or “prop” – trading.

[mserve id=”US_President_Barack_Obama.jpg” align=”left” width=”400″ caption=”US President Barack Obama” alt=”US President Barack Obama” title=”US President Barack Obama”]

Prop trading is the catch-all phrase that describes the practice of a bank using its own funds to trade its own “book”, for its own profit. Prop trading has been the source of much of the banks’ profits since the provisions in the 1933 Glass-Steagall Act that prohibited this form of trading were overturned in 1999.

I’m not going to get into a discussion on whether or not these proposals are appropriate or even if they can prevent another banking crisis in the future. Rather, I want to look at this from two points of view; firstly, what is the potential for a form of regulatory arbitrage to arise from a new wave of regulations, and secondly, could limiting the earning potential of the nation’s banks actually be detrimental to the economy’s overall recovery?

Regulatory Arbitrage

Simply put, if financial institutions feel that the regulations in one jurisdiction are too onerous or cut too greatly into their profits, what is there to prevent them from transferring more of their business to a jurisdiction with less stringent rules? All the major banks and brokerage firms have a presence in the world’s various financial centers and with the instantaneous methods of communication available to anyone with a computer and an internet connection, physical distance is largely irrelevant.

The international community’s response to President Obama’s press conference yesterday afternoon was generally positive as most governing bodies are already in agreement that tighter regulations are required. Some work towards this end is already underway, but the consensus is that any new rules must be applied consistently and within an international framework for the very reason of ensuring that a form of regulatory arbitrage is not created inadvertently.

Clearly however, there were those in the international community that were caught off guard by some of the proposals put forward by the President.

“Everybody was coordinating their work through the G20, the Financial Stability Board and the Basel Committee. The global process is not getting out of control but there is a little bit of that. Many in Europe were surprised yesterday,” an official involved in the global regulation process said.

In London, George Osborne – a member of Britain’s Conservative Party “shadow” government which is likely to form the new government later this year – said in an interview that he has already suggested that it would be beneficial to separate “retail banking from activities like large-scale propriety-trading and this was best done internationally”. Osborne described Obama’s proposals as creating “a lot of space for the rest of the world to come up with what I think would be a sensible system of international rules”. However, Osborne went on to say that the upcoming G20 meeting in South Korea is the appropriate setting to establish internationally-agreed upon rules to ensure regulations are applied consistently from region to region.

“I don’t want to do things that unilaterally damage the City of London, or unilaterally damage British banks,” Osborne added.

The reality is that banking – like most other sectors in the modern world – is international in scope; therefore, the implementation of new regulations to reduce the risk of a future banking calamity must also be international in scope.

Some of the new regulations under consideration:

  • Global – Proposal before the International Monetary Fund to impost a tax on financial transactions (spearheaded by British Prime Minister Gordon Brown and known as the “Tobin Tax”
  • United Kingdom – 50% tax on bonuses exceeding a specified limit
  • United States – Financial Crisis Responsibility Fee to be levied against banks that received bail-out money

Effect Proposals Could Have on Economic Recovery

There is no doubt that the banking sector will be subjected to increased regulation sooner rather than later. This simple fact alone will increase the cost of business for the banks themselves, and ultimately, their customers as well. However, lawmakers must be sensitive to the impact these changes could have to the economy as a whole.

The reputation of the banking sector is at a low point right now and in many cases, deservedly so, but ultimately, the banking industry provides many highly-skilled – and highly-paying – jobs to a great number of people. It is a tremendous generator of wealth for investors both large and small making a healthy banking system critical to the recovery.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.