What started as an uphill crusade by former Fed Chairman Paul Volcker to split up the biggest global banks ended with a major policy shift for President Barack Obama, who on Thursday announced his support for Volcker's plan to restrict the size and activities of the largest U.S. financial institutions. Britain's Conservatives quickly announced support for the Volcker plan, but said they would not take actions that would disadvantage Britain's financial sector.The tides began turning in Volcker's favor in mid-December, when the president asked Treasury Secretary Timothy Geithner to take another look at Volcker's ideas. Previously, Obama had favored Geithner's more moderate approach to dealing with banking reforms. But reports say that Geithner was persuaded by Volcker during an extended lunch on Christmas Eve. Some political observers, though, saw the writing on the wall as early as October, when Obama brought Volcker to the White House to explain his position to the administration's senior economic advisers.
The president was becoming more angry as he watched big banks making huge profits on speculative trading with cheap dollars they borrowed from the federal government, and then using those profits to pay huge bonuses. That cheap money had been made available to enable the banks so that they in turn could lend to small businesses and help prevent foreclosures on Americans' homes, neither of which has occurred at the level the administration had intended. Obama's anger boiled over in December when he blasted "fat cat" bankers during a television interview.
Glass-Steagall, The Next Generation
Under the Volcker plan, banks that take advantage of cheap federal funding will be blocked from investing their own money in financial markets, a practice which is known as proprietary trading. The plan also calls for new limits on the size and concentration of financial institutions. Both moves sound a lot like provisions of the Glass-Steagall Act, which was repealed in 1999. Glass-Steagall became law after the Great Depression and, with the effects of the Great Recession still being felt across the nation, more people are realizing the wisdom in that act, thanks to Volcker.
Volcker's new rules would also prevent banks from making speculative investments that don't benefit their customers, an activity he believes was a key factor leading to the financial crisis. Further, banks would be limited from using borrowed money to fund their own expansions.
Volcker definitely wants to turn back the clock to a time when commercial banks were prohibited from engaging in risky Wall Street activities. He believes those banks exist to serve the public and that is what their mission should be. Volcker thinks investment banking activities create conflicts of interest and promote risk-taking; in his view, commercial banks should only be allowed to take deposits, manage the nation's payments system, make standard loans, and trade securities for their customers, but not for themselves.
Next Stop: Capitol Hill
Volcker's proposals will require congressional approval, and a financial regulatory reform bill has already passed the House, so incorporation of the new policies into legislation will fall to Sen. Chris Dodd (D-Conn.) and the Senate Banking Committee, which he chairs. Volcker will spearhead that effort and depend on the respect he has on both sides of the aisle to get these reforms passed.
Until recently, Geithner was of the opinion that the best approach to financial reform was to limit the banks by requiring them to hold more capital in reserve to cover losses. He thought prohibitions on specific activities would be less effective, because bans would eliminate some legitimate activity unnecessarily.
But Volcker continued to make his case, picking up crucial allies along the way, including Bank of England Governor Mervyn King, and former Citigroup Chairman John Reed. Vice President Joe Biden and key Obama advisor David Axelrod were two other major supporters of the Volcker plan. Now we'll see whether Volcker can achieve the next victory in his crusade by getting a bill through Congress.
What is Inflation?
Why do prices go up?View Course »