Will Obama's banking reforms prevent another recession?

08:17, January 29, 2010      

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U.S. President Barack Obama is pushing for radical banking reforms in a bid to prevent a rerun of the 2008 financial crisis that sent the global economy reeling and sparked the worst recession since the 1930s.

But a number of critics have voiced concern over the president' s latest proposals -- which include capping the size of banks and limiting investments deemed too risky -- saying such reforms may not prevent another financial crisis.

The harshest criticisms came from those who panned the proposal as an act of presidential desperation amid high unemployment and the loss of a key Senate seat in recent elections.

Still, the plan has gained some praise internationally and some U.S. analysts said it deserves a closer look.

"While the financial system is far stronger today than it was one year ago, it is still operating under the exact same rules that led to its near collapse," Obama said last Thursday when he announced the proposal.

"My resolve to reform the system is only strengthened when I see a return to old practices at some of the very firms fighting reform, and when I see record profits at some of the very firms claiming that they cannot lend more to small business, cannot keep credit card rates low and cannot refund taxpayers for the bailout, " said the president. "It is exactly this kind of irresponsibility that makes clear reform is necessary."

But critics fret over the plan's lack of details.

"It's totally unclear how they are going to do it," said Douglas Elliott, a fellow at the Brookings Institution, of Obama's proposed limits to the size of banks.

Moreover, capping banks' size will do little to increase the financial sector's stability, he said.

Also of concern is Obama's proposed restrictions on " proprietary investments," a term Elliott said no one can really define.

"The problem is determining when an investment is 'proprietary, ' since every investment truly owned by a bank is proprietary in the sense that the bank will absorb any gain or loss," he said.

And many investments are held for reasons that support public policy, such as to provide a source of liquidity in case a bank needs cash unexpectedly, he said.

"We need to focus on the risk management of the investments ... I would rather that the risk management focused on capital requirements and other incentives than make a blanket ban on something we can't define effectively," he added.

The administration's earlier approach of placing higher capital charges and higher liquidity requirements is a better plan than forcing institutions to become smaller, he said.

Critics also point out that the president has not specified exactly what the right size of banks should be. And it remains unknown how large a financial institution would have to become to spark a financial crisis if it fails.

Critics also noted that Obama did not distinguish between banks and their holding companies, which are two distinctly different types of organizations. Banks' deposits are insured and they have access to Fed loans, whereas a holding company simply oversees a bank.

Still others said the proposal merits a closer look, although assessing the size of the nation's banks will require a high level of expertise.

Obama's plan has also grabbed international praise.

On Tuesday the Organization for Economic Cooperation and Development applauded the proposal, and an editorial in the Mainichi Shimbun, a major newspaper in Japan, expressed an interest in the idea, but stopped short of an outright endorsement.

The plan comes on the heels of an earlier one this month to levy a tax on the 50 largest U.S. banks in an effort to recoup taxpayer's losses from the 2008 bank bailout.

Some analysts said the president is tapping populist outrage toward Wall Street, which many blame for causing the recession. But critics charged that the president's policies are simply an expression of that anger, rather than a genuine solution.

Other critics contended too many restrictions could put U.S. banks at a competitive disadvantage with foreign banks. U.S. banks would simply shift restricted operations overseas and some analysts surmise that talented executives could bolt and find employment in less regulated financial hubs, such as Germany.

Obama's announcement did not play out well in the markets and the Dow Jones industrial average plunged more than 200 points as the president concluded Thursday's speech. The dive reverberated across the Pacific and led to a drop in shares at the Tokyo stock exchange.

Dean Baker, co-director at the Center for Economic and Policy Research, said the proposal's intentions are unclear.

"If the intention is to prevent banks from becoming too big to fail, why aren't we breaking up banks?" he asked, adding he is not against limiting the size of banks.

Baker said that while former Fed chief and White House economic advisor Paul Volcker has been pushing the idea for a while, the timing of the proposals -- just after Republican Scott Brown won a Massachusetts Senate seat that had belonged to Democrats for decades -- could be connected to recent elections.

"It's possible he would have done it in any case because Volcker is his advisor," he said.

Source: Xinhua
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