President Announces New Restrictions on U.S. Banking Sector

The Proposals

The announcement lacked clear details as to the nature and extent of measures to be taken, but in essence consist of two elements:

• Commercial banks will be prohibited from trading purely for their own account (proprietary trading), and banned from owning hedge funds and private equity firms. Banks will have to choose between owning an "insured depository" (normal commercial deposit-taking and lending operation) on the one hand, and owning proprietary trading operations or stakes in hedge funds and private equity firms on the other. These activities are seen as being unrelated to serving customers, although banks would be able to continue proprietary trading that is related to their customers' businesses. The announcement falls short of a formal separation between high-risk trading activities and routine commercial and retail banking functions, as existed under the Glass-Steagall Act until 1999. It is thought likely that some banks may have to dispose of certain activities, especially in view of earlier proposals already being debated in Congress that would allow regulators to compel large institutions with different but connected activities to sell off divisions that could present a threat to financial stability.
• New rules would place unspecified limits on the size of financial institutions, beyond current regulations restricting banks from holding no more than 10% of total bank deposits, but which would take into account other forms of funding employed by large financial institutions.

Populist Tone Worries Businesses

The proposals have been under development for some time, but President Obama has seized on them as a means to fight back politically. This week's loss of a Senate seat came as a major blow and potentially thwarts the ambitious healthcare reforms that Obama has cited as his number-one domestic priority. The Republicans have thrived on a populist message, criticising big government, excessive regulation, and taxation. Now the Democrats are looking to adopt a more populist tone of their own with the November mid-term election looming, and the banks make an especially tempting target. There is little public sympathy for the sector, and the Republicans find themselves in a bind as they do not want to be seen as a friend of the banks, but at the same time are unwilling to support tougher regulation. Quite how much political mileage Obama will get out of the proposals remains to be seen, but for banks and the wider corporate world the situation is ominous.

Outlook and Implications

The reaction from the U.S. banking sector has been almost universally negative, not least because the proclaimed objective is to strengthen stability, but there has been no clear link made between what is now proposed and the financial sector turmoil stemming from the sub-prime loan crisis. There is, however, clear political support for action that would restrain risky trading activities (seen by may as having little if any social or economic benefit), and directing banks to channel more resources towards greater capital strength, improved liquidity, and more lending to businesses and households. To the extent that trading activities contribute significantly to total earnings the measures are likely to be strongly resisted, since the removal of significant sources of income will weaken profitability (already reflected in the share price of major institutions) and necessitate the urgent need for replacement earnings at a time of depressed economic activity and suitable credit demand.

For European banks the threat is not so great because proprietary trading accounts for a much smaller proportion of total revenues (up to 2% compared with more than 10% at some U.S. institutions). Efforts by U.S. banks to transfer activities to London or elsewhere in Europe may be impeded by European regulators who are anxious to ensure co-ordination at an international level. Both Germany and the United Kingdom—two likely destinations for disaffected U.S. banks—are believed to be supportive of the Obama proposals and unlikely to welcome attempts to evade them. The governor of the Bank of England, Mervyn King, in particular is believed to be strongly supportive of some form of Glass-Steagall separation of trading and routine banking activities.