Sunday, May 23, 2010

Obama on track for financial reform

Now that the Financial Oversight Bill has been voted through the U.S. Senate, it is time to consider the situation.

Of course there exist TWO versions of US financial reform, the version that was passed by the Senate last week and the version that was passed earlier by the House.

President Obama's administration can cherry-pick which bits they like of which Bill, through the U.S. process that attempts to smooth the differences between the two Bills and present a single version.

Apparently, the President's administration prefers the Senate's version for its treatment of consumer protection, of the too-big-to-fail syndrome, and of the management of systemic risk.

The Obama administration does not like a provision in the House's Bill that seeks to exempt auto dealers from the supervision of the consumer protection agency. Republican senators have a touching concern for the red tape that a consumer protection bureau would create too much red tape - clearly, Republicans are more concerned by the red tape that would result than they are concerned about the protection of consumers. Naturally, it would be better to have consumer protection without red tape. There are simple means of doing so (e.g. banning loans for simple consumption, allowing loans only for investment) but neither of the US parties seems interested in simple solutions. So, as the choice is between consumer protection with red tape, or no consumer protection at all, every sensible person will prefer, even at the cost of red tape, the protection of consumers.

On the other hand, the administration prefers the way the Senate version requires banks to spin off their derivatives trading - though the Treasury has indicated that it is open to a compromise that would permit banks to trade in derivatives as long as those activities were kept separate from deposit-insured banks. How this can be done is difficult to imagine. So XYZ Bank will keep its deposit-taking activities separate from its derivative trading activities, let's say by having two different legal entities within the same overall house - let's call that XYZ House.

Now, will the market/share price of XYZ House be dependent only on its deposit-taking activities? Clearly, the market would not be that stupid, and the market/share price would also be dependent on XYZ's derivative trading activities. Since the volumes and margins involved in derivatives trading are usually many times those involved in deposit-taking, clearly the market- and share-price of XYZ House would be much more dependent on its derivatives trading subsidiary. In effect, therefore XYZ House would be an investment bank with a small deposit-taking function. The investment bank would make huge losses or profits (that's the nature of investment banking), while the deposit-taking function would profit a much smaller steady income. Since the whole matter of whether or not to separate the functions of investment banking and deposit-taking was being discussed as a result of the crisis, which made it clear that one factor causing the crisis was the merging of investment banking and deposit taking, it is not clear how the "division" of the two activities within the same house sorts out the problem. In fact, a glance at European companies, which DO separate the activites should show that the division is not, and has not been, a solution at all.

Summary: the Obama administration has chosen the right options - those that are moral, ethical, just and humane.

Let's hope that the President's administration has the gumption now to drive these through. Sphere: Related Content

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