The Obama-Volcker Act

Not a marker for Indian policy

Given that excessive risk taking by banks was at the core of the Lehman crisis, it is not surprising that US President Barrack Obama wants to rein in any resurgence of that tendency. President Obama’s economic team spent most of last year bailing out banks too big to fail. Some of these banks have now made sky-high profits and will pay hefty bonuses to their executives. That somehow doesn’t sound right, since the banks were saved from bankruptcy by taxpayer money. Surely the taxpayers should also share the new bounty. Besides, how much of the froth that we are seeing now is a precursor to a fresh crisis? Did the bailout embolden banks to pursue the same old habits? Didn’t lax regulation and unrestricted leverage play a role in the crisis? Shouldn’t that be fixed first? You could argue that banking provides the conduit (arteries) through which credit (lifeblood) flows that is critical for the revival of the economy, and hence a revival of banking was top priority. But a tighter regulatory regime is necessary too, especially to limit the risk exposure of banks. This is the philosophy guiding the new initiatives of Mr Obama, which found expression last week and in his state of the Union speech.

Mr Obama’s proposals are based on the idea that banking institutions which accept public deposits cannot speculate with that money. The brain behind these proposals is former Fed Chairman Paul Volcker. These proposals are being termed as Glass-Steagall reborn, although unlike the original G-S Act, these proposals do not prohibit banks from undertaking investment banking, underwriting securities or doing asset management, i.e., running mutual funds. This distinction, which is clear in theory, is blurred in practice, and hence may be unworkable. That’s because banks often do securities trading on behalf of their clients (shades of P-Notes from India), which the new proposals do not prohibit. But it will be practically impossible to distinguish between proprietary and client related trading. Introducing burdensome reporting requirements to sift out proprietary versus client related trades will be ultimately counterproductive. Hence it will be interesting to see how the Obama / Volcker proposals are drafted into law.

While the American pendulum swings back from excessive and unbridled deregulation toward tighter control, we must not make haste to imitate, for our pendulum is yet to swing from the other end. With three-fourth of our banking under government control, and almost one-third of all assets invested only in the public sector, our journey of financial sector reforms should be headed in the opposite direction. We need more deregulation, not less. We need more private sector presence. A kneejerk resort to a Glass-Steagall regime in India, which both left-wing and right-wing policy wonks seem to be demanding, is misplaced and ill-informed. Indira Gandhi may have been right to nationalise and control banks in 1969, but in 2010 India needs less, not more nationalisation of banks, and the sooner we have free entry of newer players, and fresh injection of large doses of bank capital, the better it will be for the economy. The success of Indian banking in having weathered the global crisis should not result in wrong lessons being learnt on banking regulation.