Page last updated at 20:56 GMT, Thursday, 21 January 2010

Q&A: Obama's bank curbs

By Martin Webber
Editor, World Service business programmes

Wall Street street sign

US President Barack Obama has proposed sweeping new rules to curb the size and risk-taking of big banks.

It is a much more dramatic proposal than anything that has emerged since the financial crisis started, roughly two years ago.

How will banks change?

Many - but not all - big banks currently combine the business of looking after the cash of ordinary citizens with a second business that involves taking bets on financial markets.

The biggest examples of such banks are Citigroup, JPMorgan Chase and Bank of America in the US, while the UK has Barclays and Royal Bank of Scotland.

Before the crisis, these banks argued that they understood the risks of what they were doing.

President Obama clearly now thinks banks cannot be trusted to manage their risks, so he wants to force them to stop their riskiest activities.

The President said banks would be barred from what he called "proprietary trading operations, unrelated to serving customers".

Proprietary trading involves a firm making bets on financial markets with its own money, rather just than carrying out a trade for a client in which only the client's money is at risk.

There is a lot of uncertainty about exactly how watertight this restriction will be.

"The devil is in the detail of how are they going to define proprietary trading", said Peter Hahn, lecturer at Cass Business School and former managing director at Citigroup.

Why is it being done now?

This is a puzzle as it is now more than a year since the financial system looked to be on the brink of collapse and some experts began calling for such radical restrictions.

But there are several possibilities.

Either this was the plan all along, but the administration was waiting for the banking system to stabilise before reshaping it.

Or, it could be a sudden shift in policy, driven by a genuine revulsion against the size of recent Wall Street bonuses.

But how much is just politics?

Some suggest it is a reaction to this week's Republican victory in an election for a crucial Senate seat.

"This is a political effort because of what happened in Massachusetts. This really doesn't do it," says Peter Morici of the University of Maryland.

"A year into the Obama administration, he should be able to say something more substantial and he can't do that. The White House was bought and paid for by Wall Street," argues Mr Morici.

"The Obama administration has facilitated a massive transfer of wealth to Wall Street and they are trying to distract the public from the inadequacy of their policies. You are seeing a failing presidency," he suggests.

What is the downside?

Most banks are desperate to hold onto their trading operations, because in the short-term they have been very profitable, even though they went very wrong in the financial crisis. So shareholders may well be disappointed.

And there could be a problem for taxpayers in the UK where the government owns most of the Royal Bank of Scotland (RBS).

If RBS has to close down businesses that are currently profitable, it will seem less valuable in the financial markets and its shares will fall, meaning taxpayers are less likely to get their money back.

There are also doubts about whether the Obama proposal would have dealt with all aspects of the financial crisis.

"Smaller US banks got into trouble buying mortgage-backed securities and putting them on their books - this isn't prevented by a ban on proprietary trading," says Peter Morici, who argues banks should be limited much further by being restricted to taking deposits, making loans and owning US government securities.

Will it happen?

The President made it clear that he is relying on the US Congress to make the proposal a reality. But his political capital is running low and the Massachusetts defeat makes it even more difficult for Democrats to get their proposals passed.

And the bankers will be lobbying hard to try to prevent the plans that they consider an unworkable return to the restrictions of a past era.

On the other hand, public anger is so intense about the banks' bumper bonuses at a time when life is still very tough for many Americans, it must have a chance of getting through.

Many Democrats have taken money from Wall Street, but they fear they may not be re-elected if they are seen as being too close to the banks.

And many Republicans do not like the existing system where failed banks have had to be rescued by the government.

There are a lot of attractions in reforms that would see risky financial activity concentrated in hedge funds which can be allowed to fail rather than ordinary banks which would need to be rescued.

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