Banking Industry Regulation Carries Both Risks and Potential Rewards, VCU Professor Says

By Tom Gresham

The Obama administration’s proposal to limit the size and risky activity of banks makes sense in its intent, but the current proposal could hamper banks’ economic development capabilities and consumer services, according to Kenneth Daniels, professor of finance at VCU.

Daniels said the Obama administration’s plans to increase regulation of the banking industry are driven by the desire to prevent another financial crisis. The current recession was caused largely by the financial sector’s disastrous dalliances in certain secondary markets, he said. The intent of the proposals – to spur economic growth by reforming the financial industry – is logical, Daniels said.

“There were major problems in the financial system and we need major financial reform since we have not really had any major financial re-regulation since the Great Depression,” Daniels said.

Still, Daniels said the administration may have overstepped in some of its specific plans to limit the size and risk of banks – changes incorporated in the proposed “Volcker Rule,” named after Obama adviser and former Federal Reserve chairman Paul Volcker. Daniels said Volcker hopes to limit banks’ risk partly by reducing banks’ non-banking activities, such as commercial mortgage-backed securities, venture capital and hedge funds, and forcing banks to focus on banking activities, such as taking customer deposits and distributing loans. That change would “take away the government guarantee of bailing out banks’ risky activity because it’s tied to deposits,” Daniels said.

However, Daniels says that these non-banking activities – when managed correctly – actually help make banks safer and allow the banks to provide critical liquidity into the markets where they are engaged. Also, the size of the country’s largest banks allows for the kind of economy of scale that leads to lower fees for customers and a better consumer experience.

In addition, keeping U.S. banks from operating as “financial supermarkets” might strengthen foreign rivals that operate without the same restrictions, Daniels said.

“When we change the size of the banks, it changes the competitive landscape and it’s possible that it could actually weaken the system by allowing foreign entities to have a greater impact on our financial system,” Daniels said.

Daniels said he believes Volcker was being savvy introducing such a strong, drastic proposal first, using it as an opening salvo in negotiations with Congress. He thinks Volcker and the Obama administration will begin to work backward from their initial proposal to find a plan that is more palatable for opponents.

The administration also announced plans for a tax of the largest U.S. banks – those with assets totaling more than $50 billion – that would be used to recoup federal funds used for the Troubled Asset Relief Program (TARP), the 2008 government bailout of struggling financial institutions. Most banks are not large enough to qualify for the tax, Daniels said, and the tax will not be felt by those that do qualify because it amounts to a relative pittance for such large institutions.

“It’s more about signaling to the American people that the Obama administration is dedicated to reform, but the actual impact on the banking sector is relatively minor,” Daniels said.