Is Obama Really Breaking up the Banks?

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ECONOMY JANUARY 27, 2010

Is Obama Really Breaking up the Banks?

Judging from all the build-up, the one thing tonight’s State of the Union address is sure to include is some presidential feistiness toward Wall Street. Rhetorically, the president has spent the last week throwing elbows at his banker adversaries. Obama announced at a press conference last Thursday that “If these folks want a fight, it’s a fight I’m ready to have.” The day before, he seemed ready to initiate the beat-down whether or not Wall Street wanted any part of it. “We’re about to get into a big fight with the banks,” he warned George Stephanopoulos. During a speech on Friday, Obama used some form of the word “fight” 14 times. “I can promise you, there will be more fights in the days ahead,” he said when turning to the topic of banks.

The substance behind this verbal barrage is twofold. Earlier this month, the White House announced a nearly $100 billion tax on banks to recoup the bailout money they took during the financial crisis. Then last week, the administration dropped what seemed like a bombshell—plans to downsize the megabanks and prohibit them from using government-subsidized money to fund risky trades. The latter in particular prompted much bleating on Wall Street. It also captured the imagination of the nation’s headline writers. A Politico article blared “Obama Takes on the Banks” the way a playground instigator yells “fiiiight!” 

What was less clear once you sorted through the details was whether the moves represented a bona fide policy shift, as much of the reporting described it, or a mere adjustment at the margins. In fact, while the policy changes are hardly trivial, what’s more striking is the basic continuity in the administration’s approach. 

Since the reform debate began back in 2008, it’s centered around two broad theories for how to prevent a replay of the crisis. Both take aim at the so-called too big to fail problem, the idea that certain institutions are so big or interconnected their collapse would threaten the entire financial system. What’s more, because these firms know the government has no choice but to bail them out if they get in trouble, they have incentives to take on excessive risks.

The first solution to this problem is the bust ‘em up approach embraced by the likes of former IMF chief economist Simon Johnson. Johnson argues that the problem with megabanks is as much political as it is economic. At a certain point, a big bank amasses so much political power it can stiff-arm regulators and chip away at regulations, even if the original rules may be sound. To effectively rein in the banks, Johnson argues, you first have to crush their political power, which, in practice, means making them a lot smaller. (A corollary of this view is that the collapse of smaller, less interconnected banks doesn’t threaten the financial system, so a smaller bank can’t count on a bailout the way a big bank can, which means it’s less likely to take crazy risks.)

The alternative theory is that shrinking overgrown banks is itself politically impossible. But, argue proponents of this view, just because you’ve accepted bigness doesn’t mean you’ve thrown in the towel. Instead, you force banks to shoulder the cost of their own bigness—by, say, forcing them to hold a lot more capital—which dents their profits and offsets the subsidy they get from being too big to fail. To that end, Diana Farrell, a top White House economic aide, recently explained that “in some sense, the genie’s out of the bottle and what we need to do is to manage [the megabanks] and to oversee them, as opposed to hark back to a time that we’re unlikely to ever come back to.” The approach is sometimes jeered as overly accommodationist, but it need not be. Even liberals like New York Times columnist Paul Krugman have signed on to its logic in some form.

In the hours after the administration’s announcement last week, many in the media saw a shift from the second approach to the first. Politico welcomed Obama to the “’big is bad’ bandwagon” and The Wall Street Journal hailed the coming of a “policy pivot.” It’s not hard to see where they got this idea. The administration was proposing limits on the size of certain financial institutions. And, perhaps more evocatively, it was vowing to stop banks that receive certain benefits from the government (like deposit insurance) from making bets for their own bottom line, a practice known as proprietary trading. At his press conference, Obama dubbed this proposal “the Volcker rule,” after the iconic former Fed Chairman Paul Volcker, who spent the last several months drumming up support for the idea.

But here’s the catch: When you talk to administration officials, it soon becomes clear that their underlying theory of reform hasn’t changed. Which is to say, they still believe that the most practical way to prevent big banks from taking destructive risks is by regulating them aggressively--and arming regulators with more powers--not breaking them up. For example, one of the key pieces of the reform proposal the administration unveiled last summer is known as resolution authority, which would allow regulators to liquidate a troubled megabank in an orderly way, so that the government wouldn’t face the choice of either bailing it out or letting it bring down the financial system. Every administration official I talked to about this told me resolution authority is still the way they intend to deal with the problem of too big to fail. The latest ideas simply won’t shrink the banks by nearly enough to make it safe for them to fail on their own (even if, as one official allows, the big banks may “shrink a bit”).

Many of the press accounts describe how Volcker persuaded members of the Obama economic team to back his approach—most famously during a two-hour Christmas Eve lunch with Treasury Secretary Tim Geithner. There’s an element of truth to this. But when you ask administration officials exactly what they were persuaded of, it’s not that their theory of reform was wrong--that, say, bank size was a major cause of the financial crisis, or that proprietary trading did the banks in. They were mostly persuaded that they could append Volcker’s ideas to their original approach while keeping its essence intact. “Our view is it’s not counterproductive,” says an official.

That’s not to say they view it as pointless. At heart, the Volcker rule reflects the principle that big banks shouldn’t be allowed to gamble with taxpayer-subsidized money. Whether or not that gambling was a cause of the crisis, it’s still offensive. It became infinitely more so as the banks parlayed their subsidy into grotesquely large profits so soon after the crisis. The perversity of this gradually earned the ire of several members of the economic team, which made it easier to persuade them it was a principle worth enforcing. And, of course, standing up for such a principle can yield political benefits--not unhelpful in the current environment. “The perception that somehow this president, this administration, was showing favoritism toward Wall Street was a problem even though it was wrong,” says another official. “Changing that perception is not why you do this. But I'd be lying if I said people weren't aware of that benefit."

Ironically, then, the practical upshot of the Volcker rule may be to advance the administration’s original reform agenda. “It’s helped turned the tide a bit,” says an official. Whatever its substantive merits, the original idea was simply too hard to sell as an ambitious reform measure. “People in a lot of ways had gotten caught up in the complexity of the issue. … It’s not black over here, white over here.” That dynamic had allowed the banks to muddy the debate and gave the GOP cover to do their bidding. The beauty of throwing the Volcker rule into the mix, by contrast, is that it forces political opponents to choose a side. “Now that we’re taking the fight to the Republicans,” the official says, “it should help get this thing done.” 

Noam Scheiber is a senior editor of The New Republic.

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posted in: economy, facebook, new york times, twitter, diana farrell, george stephanopoulos, paul krugman, paul volcker, international monetary fund, white house

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