Big banks are today’s designated villains, widely blamed for creating the financial crisis and criticized for sopping up government bailout money and then indulging in a new orgy of extravagant bonuses. To prevent the banks from acting carelessly and taking excessive risk, President Obama has proposed restricting bank activities, like prohibiting them from trading for themselves and limiting the size of liabilities.

These proposals, made late in January, come on top of others: a $90 billion tax over 10 years on the 50 largest banks to pay back bailout money; efforts to assure executive compensation doesn’t encourage excessive risk taking; and a proposal for a new consumer protection agency, among others.

“While the financial system is far stronger today than it was one year ago, it is still operating under the exact same rules that led to its near collapse,” Obama said in announcing his proposals. He went on to tap into populist, anti-bank sentiment, noting the banks are making record profits while refusing to lend to small businesses, that they are charging high credit card rates and failing to “refund taxpayers for the bailout.” He added that it was “exactly this kind of irresponsibility that makes clear reform is necessary.”

Volcker Rule

But would the latest proposals, including the “Volcker Rule” named for their champion, Paul A. Volcker — the former Federal Reserve chairman who is one of Obama’s chief economic advisors — really get at the causes of the recent financial crisis? The Volcker Rule, including the proprietary-trading restriction, has many high-profile supporters. But some experts think it misses the mark by focusing attention on the now-blurred distinction between commercial banks, which take deposits, and investment banks, which trade on their own accounts and underwrite stock and bond issues.

“All the bank proposals have nothing to do with why the crisis occurred — nothing,” Wharton finance professor Jeremy J. Siegel says of the Obama plan. “The crisis originated in the non-bank financial firms,” he adds, referring to firms like American International Group, an insurer, and Lehman Brothers, a financial-services firm that did not engage in commercial banking.

Wharton finance professor Richard J. Herring says Volcker has been pushing his ideas for at least two years. “The plan has always struck me as nostalgia for the 1980s…. [It] has little to do with the current crisis,” Herring says.

The proposals, which were announced on January 21, would prohibit institutions that take deposits — commercial banks or firms that own them — from making their own bets on stocks or other financial instruments, including derivatives. They would not be allowed to invest in or sponsor hedge funds or private equity funds. Obama also would limit each bank’s share of total liabilities in the marketplace, much as regulations limit any single institution’s market share of deposits. The proposals still have to be fashioned into Congressional bills, but they dovetail with a risk-reducing bill which passed the House in December. That legislation’s prospects in the Senate are iffy, largely because of opposition from Republicans as well as some conservative Democrats.

Critics think institutions that trade on their own accounts are essentially gambling with depositors’ money, potentially spreading financial contagion when bets go wrong. Deposit-taking institutions rely on a public safety net, such as FDIC insurance that makes customers whole if a bank goes under. The Volcker Rule is based on the premise that if the public is at risk, it can be invoked to curb risk taking. Under Obama’s proposal, the commercial banks would continue to be allowed to trade on customers’ behalf.

An article in The New York Times on February 16 notes that many current Wall Street leaders oppose the Volcker Rule, but that some of their predecessors and other finance giants support it. The latter group includes financier George Soros, former Treasury Secretary Nicholas F. Brady, former Citigroup co-chairman John S. Reed, former Wall Street executive and Securities and Exchange Commission chairman William Donaldson, and John C. Bogle, founder of Vanguard Group, the mutual fund company.

Glass-Steagall Redux?

Amid the Depression, Congress passed the Glass-Steagall Act, separating commercial and investment banks. This restriction was gradually whittled down until Glass-Steagall was repealed in 1999. In recent years, Wall Street’s behemoths have engaged in both commercial and investment banking activities, even betting — and sometimes losing — vast sums on complex, poorly understood derivatives and mortgage-backed securities.

A number of them, such as Citigroup, which was heavily involved in the mortgage-derivatives market, have required costly government bailouts in the financial crisis. The Volcker Rule is a small step toward restoring some separation between commercial and investment banking. It targets institutions like Citigroup, Bank of America, JPMorgan Chase, Wells Fargo and Goldman Sachs.

Some of Obama’s proposals, including the $90 billion tax, are sensible, according to Wharton finance professor Franklin Allen. “The tax seems perfectly reasonable …. The banks should have to pay that,” he says. Kent Smetters, professor of insurance and risk management at Wharton, notes that states often impose special charges on insurers after a company fails. “The idea of a tax on survivors to make up for losses is not a completely-out-of-the-question type of concept,” he says. “It’s done at the state level all the time.”

But, like Siegel and Herring, Allen and Smetters believe that the banking proposals miss the big picture. The centerpiece of the proposals, which involves restricting risky practices at commercial banks, would be hard to implement effectively, Smetters says. He argues that it would be nearly impossible to distinguish between trades a firm does for its own benefit and those it executes for customers. What looks like a trade done in a firm’s proprietary account can be part of hedging strategy tied to a customer’s activities, he says. “I’m just totally scratching my head on that.”

Herring adds that the proposals do not offer a remedy to the problem of institutions deemed too big to fail, or those whose collapse might potentially take the economy down with them. “It’s all very well to say that once Goldman Sachs is no longer a bank holding company, it will no longer be bailed out. This assertion has no credibility in the wake of the bailouts of Bear Stearns, [Fannie Mae and Freddie Mac] and AIG,” Herring says. Each of these institutions received government help even though they were not commercial banks.

“These proposals don’t address the underlying problems,” Allen notes. A crucial factor that led to the crisis was the Federal Reserve’s low-interest-rate policy and “global imbalances,” such as the build-up of currency reserves in Asia and the budget deficit in the United States. “These proposals do nothing to address those issues.”

Better Risk Indicators

Siegel notes that a better system is needed for recognizing risks building up in the system, such as those created by mortgage-backed securities that contributed to the recent crisis. “We have to have proper capital requirements that reflect the macro risk [posed by] these securities, and the loans that financial institutions hold.” He believes the Federal Reserve should play a stronger role in monitoring the ebb and flow of risk in the markets. “The Federal Reserve should be more alert to the macroeconomic risks in the system, and warn the financial intermediaries when those risks have increased.”

In a paper written with Elena Carletti of the European University Institute, titled “An Overview of the Crisis: Causes, Consequences and Solutions,” Allen argues that mortgage-backed securities, exotic derivatives and risky trading were not so much the cause of the financial crisis, as many people believe, but the result of two major underlying problems.

The first was the Federal Reserve’s policy of keeping interest rates extraordinarily low to help the U.S. recover from the technology-stock debacle at the start of the decade. The second was the huge build-up of financial reserves in China and other Asian countries, which created an enormous appetite for debt-related securities. Together, these factors caused a drop in lending standards and fed a housing bubble in the U.S. and some other countries. When the bubble collapsed, debt-related securities plummeted in value, sparking the credit crisis.

“There has been a tremendous focus on the private sector and what the private sector did wrong in terms of taking excessive risk,” Allen and Carletti write. “However, if the basic cause of the crisis was the real estate bubble and central banks played a role in creating that, it is really the public sector that took the main risks.” Part of the problem, Allen and Carletti say, is the tradition of independence at the Federal Reserve, which allowed Alan Greenspan, the Fed chairman at the time, to dominate rate-setting decisions. “We believe it is desirable to have a better system of checks and balances to restrain risk taking in the public sector,” the researchers argue.

One possible reform, they suggest, would modify the Federal Reserve’s function to place greater emphasis on the need to maintain financial stability. Currently, the Fed’s chief emphasis is on maintaining a balance between inflation and economic growth. Allen and Carletti also suggest creation of a “Financial Stability Board” with a staff and resources independent of the Fed and focused on threats to financial stability. Several representatives of this board would sit on the Fed’s Open Market Committee, which sets interest-rate policy.

Fair Treatment

To moderate the problem of global imbalances, the governance structure of the International Monetary Fund — a source of emergency funds to troubled countries — should be changed to give Asian countries a larger role, Allen and Carletti write. If these countries were assured fairer treatment when they run into trouble, they would have less need to self-insure by maintaining large reserves. That would reduce the fuel to feed excesses like the housing bubble in the West.

Siegel argues that the Volcker Rule does not address the most important need: a way to shut down failing institutions in an orderly fashion, the way the Federal Deposit Insurance Corp. does with failed commercial banks. “We need to have a plan for dismantling non-bank financial intermediaries,” he says.

That could be done, Allen and Carletti point out, by giving the government authority to take over non-bank institutions the way it does with commercial banks, without waiting for a shareholder vote. This can be tricky with international institutions, they acknowledge, since some countries could suffer more than others. Allen and Carletti believe this could be resolved by requiring that financial institutions use subsidiaries to operate in foreign countries rather than by establishing branches across borders. The subsidiaries would be regulated by the countries in which they operate.

The fundamental problem with the recent bank proposals, Allen notes, is that they use a piecemeal approach rather than helping build an international strategy. “They haven’t got their hands around the issue as a whole,” he says.