Business

What does the war on Wall Street mean for the big banks?

Nils Pratley

More details please. On Thursday ­President Obama declared war on Wall Street -- but what would ­victory look like?

More details please. On Thursday ­President Obama declared war on Wall Street—but what would ­victory look like? On day one, it seemed as if a break-up of JP Morgan, Morgan Stanley, Bank of America, Citigroup and Goldman Sachs was on the cards. How could it be otherwise? The president had declared that proprietary trading and sponsoring hedge funds and private equity was off-limits for banks. All those megabanks do most, or all, of those things. So surely we were looking at sweeping changes?

Now there are suggestions that ­Goldman and Morgan Stanley, which converted to formal bank status only after Lehman’s collapse in 2008, could sidestep the “Volcker Rule” by putting on their old clothes and becoming footloose investment banks once again.

In that case, they could no longer expect to be rescued by US taxpayers in a crisis. In practice, they would also have to pay more to raise capital if they stood outside the protected banking tent. But they might nevertheless choose to do so. Staff, after all, might be keen to take their chances in the part of the industry where the potential for big bonuses will surely be greater.

Goldman last year made a return on equity of 22,5%. Even if the higher cost of funding reduced that to, say 15%, the bonus pool would still be huge. But if the footloose option is open to Goldman and Morgan Stanley, Obama’s bold talk about cutting Wall Street down to size suddenly sounds a lot less impressive.

US Treasury secretary Tim Geithner then added to the confusion by saying the president’s plans were not about breaking up banks, but about reducing their risk-taking.

Maybe Geithner was merely trying to avoid the appearance of telling banks exactly how to order their affairs. That would be sensible given the amount of horse-trading that will inevitably take place. But the administration must also draw a line in the sand. Goldman and Morgan Stanley have two of the biggest balance sheets in the business—bigger than Lehman. So, even if they are not caught by the Volcker Rule, they are surely affected by Obama’s other big ambition—to guard against “too much risk being concentrated in one firm”.

The phrasing is vague, but common sense says Goldman and Morgan Stanley must shed substantial parts of their empires if Obama’s reforms are to succeed. The administration’s reluctance to spell this out is worrying.

The governor of the Bank of England, Mervyn King, has been almost alone among senior UK policymakers in expressing warm feelings for Glass-Steagall-style reforms. As early as March last year he was calling for a serious debate on the subject. By October he was declaring that the “too important to fail” problem was “too important to ignore”.

Britain’s Chancellor Alistair Darling and Adair Turner, chairperson of the Financial Services Authority, would argue that they haven’t ignored the problem. Their prescription is firewalls (to provide internal separations within banks), living wills (to allow orderly wind-downs of failed banks) and lots more capital (to reduce the likelihood of failure). This has been the broad international approach.

We know the governor welcomes those reforms, but does he think they are enough? Put another way, does he trust the regulators to assess properly the robustness of living wills and to make correct judgments about how much capital banks should hold? Would the regulators’ task be made easier if banks were split into smaller pieces? Would that help lessen the impact when smart bankers out-fox the regulators?

To date, we haven’t had clear answers from King—just warnings about “the sheer creative imagination of the financial sector to think up new ways of taking risks”. He has also said that “the belief that appropriate regulation can ensure the speculative activities do not result in failure is a delusion”.

But does this add up to a firm belief in forcing banks to separate their risk-taking and utility functions via something more substantial than a firewall? On Tuesday King appears before the Treasury select committee. This is a chance for MPs to demand a straight answer to a straight question: should the UK copy Obama’s proposed reforms? It’s cards-on-the-table time. - guardian.co.uk

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