Two controversial proposals to limit the activities of banking organizations and to restrict the size of all financial institutions appear to signal a new tone, substantive approach and urgency in the Obama administration's quest for financial reform. The first proposal, dubbed the Volcker Rule after its principal author, would prohibit banking companies from investing in or sponsoring hedge funds or private-equity funds and from engaging in proprietary trading. The second proposal calls for a cap (at an unspecified level) on the nondeposit liabilities of the largest financial companies.
They have understandably garnered significant attention from the press, policymakers and commentators. At the same time, many have failed to recognize that the Obama proposals form only one part of a broader set of reforms, many of which may affect banking companies and other financial institutions in some of the same ways as the Obama plan. Moreover, these broader reforms may well be enacted in conjunction with the Obama proposals, the combined effect of which should be considered by those assessing the implications.
Even if Congress declines to enact either administration proposal, many of their elements already are embodied in other well-advanced legislative and regulatory reform efforts. For example, late last year, the House of Representatives passed a comprehensive financial reform bill, the Wall Street Reform and Consumer Protection Act of 2009. This bill would let federal regulatory agencies determine that particular financial activities or practices pose systemic risks, in which case regulators could impose limits on the activities or prohibit them altogether. Regulators also could find that a systemically significant company poses a "grave threat" to the U.S. economy or financial stability, which would trigger a demand that the company take "mitigatory action," possibly including ending the activity, ceasing new product offerings or selling businesses. In addition, under certain circumstances, regulators could bar systemically significant companies from proprietary trading. These and other broad powers granted to federal financial regulators would enable — not require — them to impose essentially the same limits as embodied in the Volcker Rule.
Other reforms being advanced in international forums would have the same effect. For example, last summer, the Basel Committee on Banking Supervision significantly increased capital requirements for trading-book exposures. In December, the Basel Committee also proposed additional capital and liquidity standards for derivatives, trading and other similar activities.
The net effect of these and other similar reforms being adopted by federal regulators and the Financial Accounting Standards Board may be to give banking organizations incentives to limit proprietary trading and investment activities.
In announcing his proposals, Obama praised the various reform efforts and, in particular, the House bill. He made clear that his proposals to restrict financial companies' activities and size were not intended to substitute for these pending efforts but, instead, to constitute "two additional reforms."
Thus, it is entirely possible that the Obama proposals, if enacted, would complement and not replace other reforms. This could have very important implications. For example, Treasury Department officials have suggested that legislation to enact the Volcker Rule would be drafted to let banking companies wishing to avoid its prohibitions give up their banking charter, or "de-bank."
If, however, some version of the current House reform bill is enacted with the Volcker Rule, systemically significant financial institutions that de-bank to avoid the rule's restrictions could potentially find themselves subject to similar restrictions adopted by federal regulators under the powers given them under the House bill.
Indeed, regulators may face significant political pressures to take such steps if many high-profile and systemically significant companies choose to de-bank. In addition, if the Obama reforms garner support from abroad, where they were praised in some quarters, foreign banking companies may also be unable to avoid their reach.