Bank Regulations: Good Or Bad?

By Eric Fontinelle | March 11, 2010 AAA
Bank Regulations: Good Or Bad?

Financial industry titans came out in favor of increased banking regulation this February, signaling an interesting turn in the debate over new banking reform legislation. The group of financial legends includes household names like Paul Volcker, former chairman of the Federal Reserve; John Bogle, founder of Vanguard Group; George Soros, billionaire investor; among others.

In Pictures: The World's Greates Investors

The Volcker Rule
Volcker's group backs a proposal that would bar FDIC-insured banks from running trading operations for their own account. This proposal has become known as the Volcker Rule. Former Treasury Secretary Nicholas Brady was recently quoted in the New York Times, stating "If you are a commercial bank…and you wish the government to guarantee your deposits and bail you out if necessary, then you can't be involved in speculative activity." (U.S. bailouts date all the way back to 1792. Learn how the biggest ones affected the economy; see Top 6 U.S. Government Financial Bailouts.)

Yet others, such as Soros, claim this proposal does not go far enough. Just as Goldman Sachs (NYSE: GS) immediately opposed increased regulation levels, many suspect the firm would be just as quick to shed the bank to escape regulation. Thus, they argue, the Volcker Rule would still leave many "too big to fail" financial conglomerates threatening the stability of the global economic system.

Soros Group Would Limit Financial Institutions' Size
Those in the Soros group wish for additional rules that would limit financial institutions' size. This advice is straight out of Investments 101. A prudent investor holds small positions in many securities to diversify the overall investment portfolio. By the same coin, Soros wants to diversify the nation's financial institution portfolio so that if one firm fails, it doesn't take everything with it.

Opposition To The Reform Proposals
Opposition to these reform proposals has thus far been led by Lloyd Blankfein, head of Goldman Sachs. Not surprisingly, many opponents are those who have the most to gain from a laissez faire approach. But some more impartial critics believe the current proposals do not address the true causes of the financial crisis.

Blankfein's testimony to Congress' Financial Crisis Inquiry Commission lays out the opposing argument that the financial crisis was not caused by "too big to fail" banks. Rather, he argues, it was a systematic under-pricing of risk, which caused many households and corporations to take on too much debt. (Find out why good intentions can put consumers in an even bigger hole than before; see our article Digging Out Of Personal Debt.)

Blankfein: Three Factors Caused Under-Pricing Of Risk
In his testimony, Blankfein asserts that this under-pricing of risk was not the fault of the banks alone, but rather a result of three larger factors:

1. Large inflows of cash from foreign investors;

2. Interest rates held too low by the Federal Reserve; and

3. U.S. policies that subsidize home ownership.

Arbitrary Limitations On Free Enterprise?
Based on this analysis, opponents claim that the proposed bank regulations will not prevent another crisis, and that such proposals would ultimately amount to arbitrary limitations on free enterprise.

It will be interesting to see how this new legislation develops; but for now, the details of any financial reform package remain vague. Wall Street firms will likely oppose any move toward regulation that will hurt their bottom line. It is easy to vilify Wall Street, as many politicians have done, in light of recent dealings. However, Blankfein is correct in pointing out that not all of the blame lies with them.

Legislation Should Enhance Financial Stability, Not Punish Bankers
Ultimately, I think that increased bank regulation could be a good thing if it is done well. I think we can all agree that the "too big to fail" mentality must end. The well-informed and unbiased perspectives of Volcker, Soros and others serve to add much credibility to the movement for intelligent regulation. It is my hope that with their guidance, any new reform legislation will be more about enhancing financial stability than about punishing bankers.

Five bankers shaped the current financial system - though some didn't live to see the fruits of their labor. For more, read The 5 Most Influential Bankers Of All Time.

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