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News January 25, 2010 Issue

Obama Proposes to De-Link Private Investment Activities From Banks

Banks have "stray[ed] wildly" from their core mission of serving their customers, and taxpayers shouldn’t have to take it anymore.

So said President Barack Obama last Thursday as he announced further proposals for regulatory reform targeted at reducing a bank’s ability to take on risk. And an "army of lobbyists from Wall Street" isn’t going to stop him, either.

In recent years, said Obama, "too many financial firms have put taxpayer money at risk by operating hedge funds and private equity funds and making riskier investments to reap a quick reward."  These financial firms have taken these risks "while benefiting from special financial privileges that are reserved only for banks," he said.

The privileges of deposit insurance and other safeguards that prevent bank failures were not created to bestow an unfair advantage on banks operating hedge funds or private equity funds. "While the financial system is far stronger today than it was a year one year ago, it is still operating under the exact same rules that led to its near collapse," said Obama. "When banks benefit from the safety net that taxpayers provide – which includes lower-cost capital – it is not appropriate for them to turn around and use that cheap money to trade for profit.  And that is especially true when this kind of trading often puts banks in direct conflict with their customers’ interests."

To end these risky practices and close the loophole on the "unfair advantage," Obama has pledged to introduce into the financial reform process what has been dubbed the "Volcker Rule." Named for Paul Volcker, a former chairman of the Fed, Obama’s chief economic adviser, and a big proponent of the reform, the rule would ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations for its own profit and unrelated to serving customers.

The reform also calls for new restrictions on the size and scope of banks and other financial institutions. Consolidation of the financial sector would be limited by placing "broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits."

"We simply cannot accept a system in which hedge funds or private equity firms inside banks can place huge, risky bets that are subsidized by taxpayers and that could pose a conflict of interest.  And we cannot accept a system in which shareholders make money on these operations if the bank wins but taxpayers foot the bill if the bank loses."

The stock markets reeled a bit at the idea. Rolling back the clock to Glass-Steagall days is going to put a pinch on banks.

Obama says he’s ready for the fight, however.

Financial institutions’ return to "old practices" such as obscene bonuses, rapidly rising credit card rates, and failures to extend credit to small businesses is exactly the kind of irresponsibility that makes clear this reform is necessary, he said.