Is This a Step in the Right Direction

Last week, the White House web site posted a news release that proposed new regulations on banks. (http://www.whitehouse.gov/the-press-office/president-obama-calls-new-restrictions-size-and-scope-financial-institutions-rein-e)

Here’s an excerpt:

The proposal would:

1.   Limit the Scope - The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

2.   Limit the Size - The President also announced a new proposal to limit the consolidation of our financial sector.  The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.

This is the essence of the Glass Steagall Act, passed in the 1930’s after massive bank failures. It separated the business of commercial banking and investment banking meaning that banks that made loans to consumers and businesses were not allowed to also be in the business of investment banking, or ‘packaging up’ those same loans as securities and selling them to investors.

Glass Steagall was repealed in 1999 during the Clinton administration, when then Goldman Sachs CEO, Hank Paulsen lobbied congress for the repeal. He was successful and was then rewarded by the George W. Bush administration making him Treasury Secretary.

This is a step in the right direction if it passes. That remains to be seen, although retiring Senator Chris Dodd might be looking to leave a legacy as the current Senate Banking Committee Chair, and get behind the bill.

As much of a good start as this might be, it doesn’t solve the existing banking problem – assets on the books of a bank valued at original value, even though the assets are worth far less. It is this fact that I believe will eventually cause another decline in the equity markets lower; we may have even seen the start of this downturn last week.

So how far off are the balance statements of many banks?

We don’t know for sure since the suspension of mark to market accounting rules, but the rise in bank stocks correlated almost perfectly with the suspension of these rules. This from Z magazine, January 1, 2010:

What set the partial bank stock price recovery in motion in the spring of 2009 was a decision by Congress to suspend the requirement that banks report their true losses at market prices—i.e., mark to market accounting—in effect allowing banks to lie about the true conditions of their balance sheets. They immediately reported profits and their stock took off. The bank stock turnaround was almost perfectly correlated with the suspension of mark to market accounting, not with PPIP and TALF. But now, that primary means of the recovery, bank stock price appreciation, has clearly leveled off. Bank stocks have had their run and now promise to drift lower once again.

I agree.

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