By GRAHAM FROST 22/01/2010
President Barack Obama’s proposals on banking reforms have created a stink in global stock markets around the world.
In a populist measure, coincidentally on the heels of a Democrat defeat in the ‘safe’ seat of Massachusetts, Obama is calling for banks to be banned from running their own trading desks and owning, investing in or sponsoring private equity groups or hedge funds. The idea is that banks should not be too big to fail and if they do fail, there would be no government or taxpayer bail-out. This is reminiscent of the Glass-Steagall Act, which separated commercial from investment banking after 1929 and unfortunately repealed in 1999 by Clinton.
Is it really so bad?
Not really in our opinion. The proposed reforms will help prevent the gravy train of massive bonuses for unparalleled risk taking with the reluctant tax payer picking up the tab. Whilst it might hit the price of big bank shares in the short term, it will provide some stability in the longer term. Size restrictions on share of deposits would actually favour smaller banks, who would obviously step into the breach. Less profits for bank traders should mean better returns for fund managers. Clearly, stock markets think that shrinking the big banks will not only reduce their profits, but will remove the liquidity they supply to markets. But will it actually harm economic growth? Given the successful operation of the world and in particular the US economy up until 1999, that seems unlikely. Any excess economic growth these banks may have created in subsequent years can now be seen for the illusion it was and will certainly be paid for by lower economic growth in the future.
Of course, if the big banks had to make a fire sale of their non core activities, this would undoubtedly affect their price. However, given that Congressional approval is required and that a lot of lobbying is likely ahead, the probable outcome is an orderly disposal of such assets of a period of time. Even that assumes that the Republicans will not go against what is clearly the wish of the majority of angry American voters. In order for this proposal to truly succeed though, it needs to be adopted by banking regulators around the world otherwise it will simply transfer low cost risk taking elsewhere. It will be interesting to see how the UK and the European political parties respond.
For investors, the uncertainty created by these proposals may represent a buying opportunity, whilst a switch from large to smaller or new banks may be rewarding. Government and central banks are likely to continue with their accommodative stances for some time after all.
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