Will This Fix Our Financial System?

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"We are here today to repeal Glass-Steagall because we have learned that government is not the answer. We have learned that freedom and competition are the answers. We have learned that we promote economic growth and we promote stability by having competition and freedom."
-- Former Sen. Phil Gramm, on passing the Gramm-Leach-Bliley Act in 1999

"Without a system of wise restraints, gross immorality and extreme craziness will happen in markets. They need to be dampened. Sin and folly needs to be stepped on."
-- Charlie Munger, 2009

One of these guys nailed it. After a decade characterized by no growth, comic instability, and too-big-to-fail-ness leading to the opposite of economic freedom, I'll let you guess which one.

But will yesterday's proposed overhauls -- touted by some as a return to the Glass-Steagall days -- sufficiently stomp on sin and folly? There's a lot of good, and a bit of, eh, so-so, that could come from changes. Here's what's on the table:

  • Proprietary trading at commercial banks will be banned. Banks are banks, trading is trading. No more intermingling of the two.
  • Banks can't own hedge funds or private equity vehicles. Period.
  • The size of banks will be limited.

Details of how any of this will work are nonexistent. But here are a few pros and cons of the broad proposals.

Why propriety trading -- trading on behalf of shareholders, rather than clients -- was ever allowed with bank capital (much of which is explicitly backed by taxpayers via the FDIC) defies explanation. There's no logic to it. There are no societal benefits to it. It's a direct subsidy from taxpayers to banks and their employees. End of story.

Limiting the size of banks is a no-brainer. As my colleague Ilan Moscovitz and I argued, there are few sensible benefits and countless dangers in being huge. Bad decisions of any bank should lead to a failure where no one is affected except that bank's shareholders. To go further, leverage, not just size, needs to be addressed.

In short, the new rules seek to level the playing field and simplify banks. To make them easier to understand. Less like black boxes. More like utilities. That's exactly how commercial banking should be.

The original Glass-Steagall regulation segregated commercial banking and the entire investment banking umbrella. But the proposed regulation only goes after one small sliver: proprietary trading. All other investment banking duties -- market-making, underwriting, advising -- are still fair game.

Now, you'd be hard-pressed to come up with an example of proprietary trading in itself being a cause of the meltdown. It's grossly unfair to use taxpayer-subsidized money to trade with, yes, but it's a stretch to say that banning proprietary trading at commercial banks would have prevented much of anything over the past two years. Prop trading didn't break the system. Bad loans and leverage broke the system.

Ending prop trading will mainly affect Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and JPMorgan Chase (NYSE: JPM  ) , and to a lesser extent Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) .

That might seem backward, but here's the thing: Goldman and Morgan Stanley aren't really banks. They don't accept significant retail deposits like Wells Fargo (NYSE: WFC  ) and US Bancorp (NYSE: USB  ) do. Goldman and Morgan are banks insofar as they were allowed to become bank holding companies in late 2008 to avoid collapse.

With the proposed rules, it seems they could (and probably would) just forfeit these bank holding charters and carry on as unprotected trading vehicles. This, though, would inject more risk into the financial system. We'd be right back to September 2008, with investment banks susceptible to bank runs, and without access to the Federal Reserve when the brown stuff hits the fan.

Goldman and Morgan Stanley being given the benefits of real banks is unfair and unreasonable. Yes, yes, yes. But it's no doubt safer than letting them run around unfettered. We need to ban systemically risky behavior, not simply segregate it.

By themselves, the proposed changes also wouldn't have prevented:

  • The capital-structure flaws of Bear Stearns and Lehman Brothers.
  • AIG, at all.
  • Fannie Mae or Freddie Mac.
  • Derivatives.
  • Commercial banks making bad loans.

So I'm happy these changes are being proposed. I'll cross my fingers and pray they get passed. But don't assume that they represent a cure-all. This is simply one step in what needs to be a broad, encompassing overhaul.

Will it fix the financial system? Absolutely not. But it's a step in the right direction.

What do you think about the proposed regulations? Share your thoughts in the comments section below.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.

Read/Post Comments (10) | Recommend This Article (27)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 22, 2010, at 11:39 AM, Caroll56 wrote:

    This is a good plan for the country and the banks. Let's see who opposes it purly for political reasons.

  • Report this Comment On January 22, 2010, at 1:22 PM, Clint35 wrote:

    As usual this plan doesn't go far enough. It's not good enough or far encompassing enough. Our politicians serve themselves and the big money that pays them not to do too much. But they had to do a little something to make it look like they're trying to change things. We the people have been crying out for changes for a few years and there's a lot of us, so that means a lot of votes. But they don't wanna make companies like MS and GS mad either because then they might lose campaign contribution money.

  • Report this Comment On January 22, 2010, at 3:58 PM, miteycasey wrote:

    repeal Gramm-Leach-Bliley Act

  • Report this Comment On January 22, 2010, at 5:11 PM, langco1 wrote:

    the depression in the US is close to getting out of control as it pushes the country closer to a major collapse......

  • Report this Comment On January 22, 2010, at 8:30 PM, Hevi wrote:

    No, this won't fix the problem. The banks will look elswhere for profits and it will show up as more fees and steeper penalties for customers. I agree that this would not have prevented the financial collapse of 2008. Lending to QUALIFIED buyers will fix the problem. Not everybody can afford to buy a home and therefore they should not try to buy a home.

  • Report this Comment On January 23, 2010, at 8:32 AM, redwood5 wrote:

    i agree changes need to to made in our banking system. But the current administration refers to the banks like public enemy number one. We need the banks to repair the economy. We should be working with them to correct things, not attacking them at every turn.

  • Report this Comment On January 23, 2010, at 3:23 PM, xlazox wrote:

    With respect to Fannie/Freddie: how about we make ALL banks hold on to their loans -- yes, you heard me right!

    No more doing loans, only to sell them off. Let Fannie/Freddie wind down to nothing. Make the lenders hold onto their loans until maturity.

    Yes, it would mean higher interest rates across the board. But in reality, by doing loans and pushing them off to Fannie/Freddie, those doing those loans saw no risk! Put the risk back in their hands.

    This would also lead to less credit availability to those with poor credit. Again, not necessarily a bad idea.

  • Report this Comment On January 24, 2010, at 1:11 PM, damilkman wrote:

    I'm interested in Fool's opinions. Why not limit how leveraged any entity can get? It seems like when those limitations were relaxed, is when we got in trouble.

    Also why not fix the ratings agencies. They had no buisness rating certain toxic vehicles as AAA+. If they rated some of these risky investments as they should have been, no one would have been duped.

  • Report this Comment On January 24, 2010, at 4:05 PM, marketjunkie08 wrote:

    NOO! Simply put if you look past the smoke screens you will find out. That the new deal put into place buy F.D.R. actually worsened the great depression. Jobless and the "Main Street" economic indicators did not rise above 1933 levels until the 50's. Long after the F.D.R. administration and brought on by the return to less restrictive business.

  • Report this Comment On January 25, 2010, at 8:33 AM, BMFPitt wrote:

    This is nice, but it should be done in addition to a constitutional amendment preventing the government from bailing out any private entity under any circumstances ever.

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