Smart regulations

More regulation is not the solution; what we need is smart regulation. By this metric, Obama's proposal fell far short of it. The following piece is by far the most intelligent analysis I have seen.

From WSJ:

President Obama has acquired the sudden appetite for a fight to rein in Big Finance. But he needs something else even more: a coolheaded understanding of where the riskiness really lies in the banking sector.

In an impassioned speech Thursday, the president said he wants financial-overhaul legislation to include measures to stop banks engaging in proprietary trading and investing in hedge funds and private-equity ventures.

On the surface, that makes sense. After the financial trauma of recent years, something decisive had to be done to prevent banks putting the system at risk again through these kinds of activities. Bear Stearns's hedge funds helped spark the credit crisis. Banks have taken massive hits from real-estate investments made by their principal investment arms, including Goldman Sachs Group, whose losses in this area have totaled nearly $4 billion since the start of 2008. And who can forget the soured mortgage bet that helped trigger Morgan Stanley's $7 billion trading loss in the fourth quarter of 2007?

But two big questions hang over the president's push. First, will these moves address other activities that carry as much potential danger? Second, which firms will be affected?

On the first, the real headache lies in deciding how broadly to define proprietary trading. For instance, trading includes the process of amassing and managing inventories of securities and derivatives. Banks say most of that is to serve clients, but they also trade around those positions on their own balance sheets, creating a gray area. A further problem: Banks can take huge losses from asset inventories built up for other reasons. That happened to Merrill Lynch and Citigroup, with subprime mortgages being packaged into structured securities and leveraged loans they intended to sell on. Somewhere in the overhaul there also have to be regulations to protect balance sheets from potential risk-asset buildups that aren't straight proprietary trading positions.

And with big securities operations, the liability side of the balance sheet can't be ignored. Losses on assets can make a bank's creditors skittish, leading to a run. That is why Mr. Obama needs to back stringent changes to make market funding safer. Last week's bank-liability tax was one avenue, but he also needs to stop the foolhardy taxpayer-backstop for banks' market funding included in both the House and Senate bills.

On the second question, President Obama seemed to focus his speech on deposit-taking institutions with large securities businesses. Among one of the many areas left very unclear was what would happen to the likes of Goldman Sachs and Morgan Stanley, which could easily unload their small deposit-taking banks. Another big uncertainty is how rules would apply to securities subsidiaries of foreign firms, to avoid giving them an unfair advantage.

There is clearly a reasonable chance the seemingly-rushed-out plans get watered down or held up in Washington. But investors still need to think about who would get hit hardest if they occur. The big deposit-taking banks with large securities arms—Bank of America, J.P. Morgan Chase and Citi—could become far more heavily weighted toward traditional commercial banking. Net income at BofA's global-markets unit was $7.2 billion, versus $6.3 billion for the whole bank. J.P. Morgan's investment bank accounted for nearly 60% of overall earnings in 2009.

Meanwhile, it is unlikely that Goldman Sachs or Morgan Stanley call pull off a Houdini-like escape by unloading their deposits. If they do, regulators may choose to push similar restrictions through capital rules and other means instead.

Goldman acknowledges that about 10% of total revenue comes from pure proprietary trading.

As President Obama braces for a fight with the Big Finance, the banks have plenty of reason to take him on.