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Obama's financial reform falls short—A Commentary by Jonathan R. Macey ’82

The following commentary was posted on Politico on January 22, 2010.

Obama's financial reform falls short
By Jonathan R. Macey ’82

The one thing everyone agrees on about the Massachusetts Senate election is that it showed voters are frustrated and furious at politicians. President Barack Obama is rapidly joining Congress as a primary target. And after his Thursday news conference on bank regulatory reform, Obama may deserve to be the focus of this anger.

Instead of bringing real change, Obama’s plans seem more likely to do the opposite of what he says he wants.

Obama said that large financial institutions almost ruined the U.S. economy because they took “huge, reckless risks in pursuit of quick profits and massive bonuses.” Unfortunately his latest solution, long on political rhetoric and short on substance, is likely to make the financial system more fragile and more susceptible to government bailouts.

You do not have to be a financial genius to figure this out.

First, Obama proposes to limit the scope and size of large financial institutions. But he ignored suggestions to break up the existing financial behemoths, like Goldman, already in the “too big to fail” category. Instead, his proposed law would simply prevent other, smaller institutions from getting larger.

Of course, this only benefits existing companies, by shielding them from competition. And, of course, these existing companies would still be too big to fail.

So, when Obama says: “I'm also proposing that we prevent the further consolidation of our financial system,” he should not be surprised when people notice the word “further.” The problem isn’t further consolidation of the banking industry. The problem is the consolidation we already have. This is one big reason for the public’s anger.

Obama also wants to prevent financial institutions from operating “hedge funds and private equity funds while running a bank backed by the American people.” This sounds good - but only for a second. It doesn’t take much longer to realize that some of the biggest bailout recipients - like Bear Stearns and AIG - weren't taking deposits. And they got bailouts anyway.

We are long past the point at which anybody could believe that the government safety net extends only to federally insured banks. Well, maybe long past the point at which anybody outside of the administration believes that.

In other words, it solves nothing to restore the old wall between investment banking and commercial banking if the federal government is going to continue to bail out both sides of the wall.

This scheme gives us all of the inefficiencies of the old, balkanized financial system and none of the advantages of limiting the government’s exposure.

True, bank stocks tanked on the news of Obama’s proposals. But just because his proposals are bad for banks doesn’t mean they are good for taxpayers.

Obama’s proposals were not entirely counter-productive though. He did, finally, endorse the plan to prohibit proprietary trading of financial securities, including mortgage-backed securities, by commercial banks funded with depositors’ cash. This is the plan Paul Volcker has been advocating for a decade or so.

Unfortunately, unless it is part of a broader reform package, this isolated reform won’t do much. The problem remains that Obama, along with his Treasury Secretary Timothy Geithner, and his top economic advisor Larry Summers, all support extending the government safety net beyond commercial banks. They want it to cover all sorts of other financial institutions - including insurance companies, hedge funds and investment banks that can continue to trade in derivatives and other risky financial instruments.

Merely limiting commercial banks’ proprietary trading activities will not come close to solving the basic problem. The big problem is not excessive risk-taking by commercial banks, it is the excessive risk taking by any and all financial institutions that are going to be bailed out by taxpayers if the risks turn bad.

Obama was right Thursday when he said that U.S. taxpayers were “forced to rescue financial firms facing a crisis largely of their own creation.” But his proposal does not fix this. To do that, the government needs to figure out a way to make a credible commitment to stop bailing out banks.

And the only reasonable way to do this is to break up the banks into pieces that are too small to bail out. Something else that Volker has been pushing for. He has long said that banks are too big to fail are too big to exist.

To be blunt, Obama was not exactly telling the truth when he said, “Never again will the American taxpayer be held hostage by a bank that is too big to fail.” Financial behemoths eligible for bailouts because they are too big to fail are sure to continue to do exactly what the president claims he is preventing them from doing - which is to “take risks so vast that they posed threats to the entire system.”

Jonathan R. Macey, the Sam Harris Professor of Corporate Law, Corporate Finance & Securities Law at Yale Law School, is the author of “Corporate Governance: Promises Kept, Promises Broken.”