United they stood

Bank reform: The overhaul of the global financial system has entered a new, more complicated phase. For two years, a fragile multilateralism has prevailed as the world’s largest economies agreed that changes should be designed and adopted on a global basis. The task of redesigning financial regulation was largely delegated to central bankers, regulators and other technocrats.

That consensus is creaking following President Barack Obama’s double-barrelled attack on Wall Street investment banks. The new tax on banks’ wholesale liabilities and the planned prohibition of proprietary trading by deposit-taking institutions both complicate the aim of getting a new effective global regime for regulating the industry — but in different ways.

Look first at the new tax. In principle, it is sensible to charge large financial institutions for the implicit guarantee they receive from taxpayers when they rely on hot short-term money to fund themselves. But there is already a global push, under the aegis of the G20, to boost the size of banks' capital and liquidity cushions. This exercise, being masterminded by the Basel Committee, has now entered the “calibration” phase — where the precise numbers are being modelled.

The problem is that the new levy to some extent does the same job as the planned new Basel rules. There is a risk therefore that the cumulative effect of regulations and taxes banks could be so weigh down banks that they rein in lending, crimping the economic recovery. Of course, it would be theoretically possible to shave the capital and liquidity requirements a bit to make way for the new tax. But coordinating that over multiple jurisdictions will be quite tricky now the US has moved unilaterally.

The proposed “Volcker rule” — which would ban proprietary trading by banks — is potentially an even bigger spanner in the works. This is because it diverts attention from the fundamental causes of the crisis by scapegoating one particular area. The Volcker rule would not have stopped Lehman Brothers going bust, as it was not a deposit-taking institution. Nor would it have prevented bailouts of Fannie Mae, Freddie Mac, AIG, Washington Mutual, Wachovia and so forth. It largely misses the mark.

During the crisis, there was excess risk-taking across the piste. Much of this was related to straightforward lending. Singling out proprietary trading may work well on a political level in the United States; it may even appeal to some politicians elsewhere. But it could undermine the difficult task of getting all countries to sign up to stronger rules on capital and liquidity which is necessary to hit the broader problem of risk-taking.

The Obama administration says its plans are also designed to tackle the “too big to fail” problem. But there were global moves afoot to address this too. First, capital and liquidity cushions were going to be made especially fat for the biggest, most complex banks. Second, big banks were going to be encouraged to draw up “living wills”, which would allow them to be packed off to the knacker’s yard if they ran into trouble in a manner that prevented the whole financial system being dragged down with them.

Again, in theory, it may be possible to combine all these ideas in some modified form with the Volcker rule. But there is only limited legislative appetite for pushing through complex changes to financial regulation. The risk is that the world will end up with a patchwork hodge-podge.