Off with their heads, big banks are curbed

At last the Obama administration seems to be contemplating a decisive move against America's banking elite. Following the recent electoral setback in Massachusetts the proposals laid down by former Federal Reserve chairman, Paul Volcker, to reduce the market power of the banks, are being dusted off.

The administration did launch a modest regulatory-reform initiative in summer 2009, proposing new consumer protections and some measures to strengthen financial stability, but the measures were fought every inch of the way. And early in 2010 a new bank tax was proposed that aimed to raise about $90 billion (Dh330.5 billion) over a decade or so but that would have represented only about 1 per cent of banks' profits.

It is no surprise that the banks have tried to resist reform. The existing business model allows them to take the upside when they win, and hand over the downside to taxpayers when they lose. This encourages excessive risk and threatens repeated cycles of boom-bust-bailout. Indeed, Andrew Haldane, head of financial stability at the Bank of England, calls this our "doom loop".

The reforms proposed by Volcker would impose restrictions on banks similar to those contained in the Glass-Steagall Act, the depression-era legislation that separated commercial banking and investment banking.

The dilution of Glass-Steagall, and its repeal in 1999, allowed banks to engage in "proprietary trading" enabling them to use depositors' savings to trade for their own account.

But the Obama administration must go further than prohibiting proprietary trading by commercial banks and do two things. First, capital requirements should be tripled not just in the US, but across the G-20 so that banks hold at least 20-25 per cent of assets in core capital. That way, shareholders rather than regulators would play the leading role in making banks behave.

Second, if banks are "too big to fail", they must be shrunk, so taxpayers do not need to bail them out every time a crisis erupts. In the US context, the Riegle-Neal Interstate Banking Act of 1994, which set a size cap so that no bank can have more than 10 per cent retail deposits, needs to be amended.

Obama is right to get tough with the six largest US banks which now have total assets worth more than 60 per cent of GDP.

This is an unprecedented degree of financial concentration. As Teddy Roosevelt pointed out more than 100 years ago, concentrated economic power tends to take over political power, which runs counter to the democratic tradition. We have now learned that it also runs counter to sound economic policy.

Simon Johnson, a former chief economist at the International Monetary Fund, is a professor at MIT's Sloan School of Business, a senior fellow at the Peterson Institute, and the co-author of the forthcoming book 13 Bankers.