Bank Busters

The Obama administration's schizophrenic affair with investment banks took another unfortunate turn this week. While Wall Street has been busy doling out compensation packages that rival the bonuses of the frothiest days of 2007, the White House has been busy trying to position itself as the avenger of Main Street. A hundred billion dollar bank tax is now on the agenda for debate (see recent post). But the proposal that has the greatest potential impact on finance as we know it is a prohibition on banks using customer deposits to finance trading operations.

While I support some sort of special tax, I do not support the proposed ban on risky investing by banks that accept customer deposits. It is clear that the government does not want banks to stop investing and trading altogether. Despite the tumult of the last two years, it is important to remember that the core business of finance is actually good for the world: moving capital from lenders to borrowers does wonders for real economic development. The difficult problem we face is how to regulate that process so as to foster economic growth, create fair outcomes, avoid systematic meltdowns, and keep taxpayer dollars out of Wall Street's hands.

Separating deposits from banks' trading operations would not improve the financial system. It might very well make it worse. Recall that in the Fall of 2008 firms with large reservoirs of customer deposits were best able to ride out the storm. Bear Stearns, Lehman Brothers, and A.I.G., on the other hand, did not have significant customer deposits. This is because F.D.I.C. insured deposits were a remarkably stable source of capital for banks. As the financial world unraveled, customers happily left their deposits in their accounts at J.P. Morgan Chase, Citi and Bank of America. Other sources of bank capital - the repurchase market, the commercial paper market, and the bond market - dried up. Without access to capital, banks were forced to sell assets at fire-sale prices to repay their obligations as they came due. The result was a market collapse and trillion dollar government interventions. One of the major lessons of Fall 2008 is that banks were buying risky assets with capital that could dry up very quickly. Customer deposits were a bright spot on banks' balance sheets; they were a source of stable capital throughout the crisis.

So why would the administration want to discourage banks from using a more stable source of capital? I don't know. Perhaps they believe that by taking away one source of capital they can reduce the amount of investing that investment banks do. This is probably correct. But surely we would want to restrict the sources of capital that are least stable first. And remember that we do indeed want banks to take some risk; investment is a good thing. Cutting off deposits from investment banking removes a stable source of capital. Such a policy could increase risk while decreasing investment and economic growth. Obama's team needs to go back to the drawing board.

Also check out this Bloomberg article about the proposal.