Obama sides with the state solution in Wall St attack

Barack Obama is finally taking on Wall Street, apparently prompted to action by the voters of Massachusetts. But he’s taking the wrong approach.

There are hundreds of competing ideas on how to stop the banks needing trillion-dollar bail-outs. Obama has chosen three, but they are the wrong three:

1. No proprietary trading
2. No owning or “sponsoring” hedge funds or private equity
3. A cap on size for deposit-taking banks

This is not to defend the banks: they made some stupid decisions, helped out by an unending appetite for cheap debt from consumers and a global debt bubble created by China’s surplus, America’s over-consumption and Alan Greenspan’s Federal Reserve. It is right that the banks should be reformed, to prevent future bail-outs.

But these actions fail to get to the root of the problem. The banks had acted just like any other borrower when presented with cheap debt (and dumb regulators): they borrowed as much as they could (often leaving them an astonishing 50 times geared), and found ways to use it from which they thought they could make money. Lenders to the (big) banks exercised no control, because they thought – correctly – that they would be bailed out if the banks failed.

The best way to fix this problem is to find a way to allow the banks to fail. If this can be put in place, the market will itself control the banks, by increasing their cost of borrowing when they take bigger risks (more transparency may be required). If investors fail to control the banks they invest in, the bank can be left to go bankrupt – as smaller banks already do. Bondholders would lose the bulk of their money, as their bonds convert into equity, either by making all (or perhaps just most) bonds explicitly convertible, or through laws requiring conversion if a bank fails.

Sure, investors will demand to be paid more to buy these (now riskier) bonds, but that just means the banks will be paying their true cost of capital, something that will lead to lower profits and lower bonuses – and probably a return to a smaller finance sector, where smart people sometimes choose to work in places other than Wall Street or the City.

But Obama has taken a different route: instead of forcing the market to take control of the banks, he wants the state to do so, through limits on what the banks can do. Call this a “socialised” route, if you’re in opposition, but whatever label you use it is far less likely to be successful, since it assumes that banks are too big to fail and always will be. The current crisis was not caused by proprietary trading, was not caused by hedge funds, and was not caused exclusively by deposit-taking banks: Goldman Sachs and Morgan Stanley converted into commercial banks, after all, in order to be bailed out, while Bear Stearns was not allowed to fail in spite of being a relatively small investment bank with no deposits.

There would be merits in Obama’s plan, if his earlier $90bn-over-a-decade bank levy was also made permanent, as an alternative to the market solution: if you accept banks are always going to be too big to fail, the risk to the taxpayer needs to be reduced. But this is a second-best, and reliance on regulation has a dismal history.

Luckily, Obama is likely to realise this: both the FT and the Wall Street Journal dislike the plan, although the WSJ, interestingly, thinks it shows Obama at least understands the problem of moral hazard.

There is little sign, though, that the ideas are properly understood in Britain. If the Treasury had any understanding of moral hazard, the relatively small Northern Rock should have been allowed to fail in the first place – along with other hopeless mortgage banks, which eventually had to be rescued in spite of the Rock action – and there is no way a minor Scottish building society with no systemic implications would have been bailed out.

This is a state vs markets debate, but the political parties have not woken up to that yet. Strangely, both the British Conservatives and the US Republicans seem prepared to be on the side of the state.

EDIT: I forgot to include a link to the excellent paper from last year by the Bank of England’s Andrew Haldane. For anyone who still thinks the banks should be left alone, this shows how they gamed the system.

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Christopher Cook is an FT editorial writer. Before joining the FT in 2008 as a Peter Martin Fellow, he worked for three years for the Conservative party.

Lorien Kite is deputy comment editor, a post he took up in 2009 after four years as a commissioning editor on the analysis page. He joined the FT in 2000.

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