One ongoing critique of the Obama regulatory reform plan is that it would enshrine "too big to fail" banks, making them not only invulnerable to regulators, but also invincible against competitors. It's certainly true that the proposal doesn't push to resurrect barriers between commercial and investment banking. Nor does it set an arbitrary size threshold over which banks would be banned. But, what's not in the plan on systemic risk is dwarfed by what's in it. By imposing an awesome array of tough regulatory and capital standards, the Obama administration would create sharp downdrafts that force even the current colossi of Wall Street to reconsider their combined charters.
Even if the plan is whittled down on the Hill, it's a formidable challenge to any firm under the aegis of the Federal Reserve Board, the Securities and Exchange Commission or the Commodity Futures Trading Commission. Proposals are in the works to implement as much of the Obama plan as possible under current law. First up, the Federal Deposit Insurance Corp.'s restrictions on private-equity firms, derived in large part from the administration's tough approach to mixing banking and commerce.
Implementing as much of the plan as possible as quickly as they can serves two regulatory purposes: first, it begins reform for a large swath of the financial services industry and, at the same time, it changes the political dynamic in the regulators' favor. The more big banks come under tough rules, the more they'll want them applied also to nonbanks to share the fun. Given the scope of regulatory power over the biggest bank holding companies — which now of course include huge investment houses — there's little the Fed can't do to them if it wants to — and it wants to. New law is only needed to cement the rules and apply them evenly so that no one can get out of the systemic-risk fold through sleight of legal charter.
So, if the rules are coming, how will they force a complete rethink of the consolidated, diversified financial holding company? The answer lies in the details of the Obama plan, details written with the sure hand of seasoned federal regulators. Key sections touch on new capital standards, interaffiliate transactions — yes, we know that sounds dull — and activity restrictions. Singly, big firms might be able to finesse these; together, they will force formidable change.
The new holding-company capital rules will include not only a tougher leverage requirement — a first for new bank holding companies like Goldman Sachs — but also capital based on assets on and off the balance sheet. Regulators will also impose capital based on liquidity, concentration and related risks, taking the toughening Basel rules and turning the dial up more than a bit for the biggest BHCs. Recall that equity positions held in a BHC are already punished under Basel II and then think about what new rules sparked by the crisis will look like for BHC proprietary trading — an activity the FRB wants out of the holding company because, like Paul Volcker, it doesn't think it ever should have been allowed there in the first place as a profit center.
If capital doesn't scare the systemic-risk boys — and it very much should — turn to the discussion of interaffiliate transaction restrictions also buried in the details of the White House's white paper. If there is any doubt that the FRB and Treasury want trading out, take a look at the recommendation to move over-the-counter trading from insured depositories. The industry has focused a lot of energy on the broader derivatives reforms in the administration plan, but this recommendation — largely possible under current law — would rewrite the OTC market at least as dramatically as the higher-profile proposals starting to wind their way through Congress. The banks' biggest friend here will be the Office of the Comptroller of the Currency, but at the least new barriers within banks for OTC activities will be mandated if the activity can be saved.
Still unconvinced about the systemic-risk redo for the largest firms? Then, take a look at the activity restrictions. Again, these bear Mr. Volcker's mark, following through on much in the Group of Thirty report he spearheaded (in collaboration with Larry Summers) in the months leading up to the election. The activity restrictions would take any activity close to commerce out of any firm that tripped the systemic-risk wire. In fact, all parents of insured depositories would need to toe the line on current BHC restrictions, confining parent companies to finance and limiting banks largely to intermediation. Think narrow bank and then suck it in some more.
The activity restrictions are perhaps the toughest political sell in the systemic-risk plan — even taking into account the furor over the Fed's role. The administration is proposing something Congress can rarely, if ever, bring itself to do: take something away from powerful interests attached to their holdings. GE, for one, is already mounting a vigorous push against the plan, and its political might is not to be trifled with.
However, like other big nonbank banks, GE is fighting an uphill battle. At the parent-company level it isn't as outside the banking sphere as it likes to think. It was among the very first to drink at the Temporary Liquidity Guarantee Program trough. The FDIC created this facility to protect bank funding sources at the height of the crisis, but instantly let GE take down more than $100 billion in debt backed by the deposit insurance agency.
Although the Fed has started to shutter some of its facilities, it and the FDIC are far from the back door on all of the backstops they rushed to put in place last fall. Further, market volatility means that both banks and nonbanks may well be big-time back at the backstop window.
Trying to persuade Congress that nonbanks aren't banks even as they use facilities built into current law only for banks will be, at best, tricky. This brings us back to our conclusion: very large firms that own insured depositories are in for a strategic reconstruction from the regulators for sure. This will force wholesale franchise rewrites that redistribute the pieces on the banking game board, reducing size, isolating insured depositories and moving the traders' desk — and that's before Congress gets to work.