Volcker's Capital Idea: Getting Back to Real Banking

 |  Includes: BAC, C, GS, JPM, MS, PNC, USB, XLF
by: Balance Sheet Future

The U.S. banking industry will be recapitalized in the next six months. Whether through private capital or taxpayer money, the banking system will move on from its darkest hour. In fact, old-fashioned banking has never been better. Total deposits at FDIC insured institutions grew by $307.9 billion or 3.5% during the fourth quarter of 2008, the largest percentage increase in ten years. The increase in deposits comes when deposit spreads are widening, as the interest rate paid to depositors dropped with the Fed’s rate cuts of the past two years. The Fed wants banks to be profitable so they can internally generate capital to fill holes created by losses.

Once the deleveraging process is over smaller and mid-size banks with clean balance sheets and a renewed focus on offering traditional financial products to their business and consumer customers will be profitable. The question is what will become of the largest banks; Citigroup (NYSE:C), Bank of America (NYSE:BAC), JP Morgan Chase (NYSE:JPM), Goldman Sachs (NYSE:GS) and other commercial institutions that have segments focused on “risk-prone capital market activities.” Last week in his Testimony to the Joint Economic Committee, Paul Volcker discussed removing the “capital market activities” from the institutions that focus on “relationship oriented” financial services.

Taken together these banking organizations (large systemic organizations) should be predominantly “relationship-oriented”, providing essential financial services to individuals, businesses of all sizes, and governments. To help assure their stability and continuity and limit potential conflicts of interest, strong restrictions on risk-prone capital market activities e.g. hedge funds, equity funds, and proprietary trading would be enforced.

At the same time, trading and transaction-oriented financial institutions operating primarily in capital markets could be less intensively regulated, although stronger registration and reporting requirements would be appropriate. In instances where the institutions are so large or otherwise so complex as to be “systemically” relevant, capital, leveraging and liquidity requirements would be imposed.”

Volcker’s idea of a banking system that provides for risk taking with truly private capital, not capital that is backstopped by the taxpayer, makes sense. The current financial crisis clearly shows the problem of leveraged risk-taking; a business that public capital (through commercial bank deposits) should not be near.

The administration and Federal Reserve remain focused on recapitalization and trouble asset problems and will later address a new framework for the financial industry. In his testimony to the Senate Budget Committee, Chairman Bernanke asked congress to focus on restoring stability and away from long-term effects:

Policymakers must remain prepared to take the actions necessary in the near term to restore stability to the financial system and to put the economy on a sustainable path to recovery. But the near-term imperative of achieving economic recovery and the longer-run desire to achieve programmatic objectives should not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances.

I hope the administration considers Mr. Volcker’s thoughts as it finalizes the bank bailout/recapitalization plan. The administration’s current course of action focused around additional capital to cover losses does nothing to solve the deep-rooted problems of the financial system. During restructurings business segments not core to the institution’s objectives are divested or wound-down. I hope that as the financial industry restructures, leveraged risk taking is left to private capital and the taxpayer, with their bank deposits better protected against future losses and bailouts.

Disclosure: short JPM