Back to Banking Basics

Oranges within Apples by Osman Azami

Although some may disagree, Wall Street does serve some productive purpose in the United States economy. Although the purpose of many financial institutions is becoming less clear, and they are certainly not doing God’s work—as the CEO of Goldman Sachs Lloyd Blankfein argues—they are needed. They invest. They innovate. They provide small businesses with the opportunity to grow and employ more Americans. We often lose sight of this. However, in recent years, so has Wall Street. Banking is not what it used to be. Since the repeal of certain provisions of the Glass-Steagall Act in 1999 that allowed financial institutions to act as commercial banks, insurance companies, and investment banks, banking has evolved into a complex game with the players seeking to maximize profit in whatever way possible. They no longer seek to produce something—directly or indirectly—just gamble and profit. And, this attitude has led to the decay of Wall Street and the rest of the world economy. Any reform must focus on transitioning banking back to basics.

When consumers deposit money into a bank, they expect it to be used for ordinary bank operations—but not speculative activity. They need assurance that it’s safe. In response to the plummet in consumer confidence and threat of bank runs in the Great Depression, the federal government passed a host of financial reform measures to achieve two somewhat similar ends: restore confidence and prevent another disaster from happening. One such measure was the creation of the Federal Deposit Insurance Corporation, which, at the time, insured deposits up to $5,000—that number has since become $250,000 as of 2008 and is a vital safety net for depositors. In addition, as a part of the New Deal legislation, the Securities and Exchange Commission was created in order to provide greater transparency and information to prospective investors. In 2010, we find ourselves in a similar situation—blind to the $600 trillion derivatives sector of the economy and distrustful of Wall Street. Washington aims to rebuild and to prevent future crashes by restoring confidence and increasing transparency. However, at the same time, Wall Street continues to engage in risky behavior behind closed doors that threatens others’ well-being.

One of the hotly contested provisions of the current financial reform bill has been the Volcker Rule, named after former Federal Reserve Chairman Paul Volcker. Endorsed by President Obama, the plan essentially seeks to repeal the repeal of Glass-Steagall and separate commercial banking functions from investment banking. In other words, a bank cannot use its own money to invest in stocks, bonds, derivatives, and it may not own or act as a hedge fund. The purpose of this proposal would be to limit the speculative activity that played a large role in worsening the financial crisis of this decade. In a letter to the Wall Street Journal in support of the Volcker Rule, five former U.S. Treasury Secretaries who have served both Republican and Democrat Presidents wrote that restricting proprietary trading is a “key element in protecting our financial system and will assure that banks will give priority to their essential lending and depository responsibilities.”

As the current Senate bill in the Banking Committee stands, the Volcker Rule is included. In essence, this plan is at the heart of any legitimate reform that intends to restore banking to boring yet safe basics. The risk a financial institution takes on needs to be lessened. Nevertheless, it will be subject to bitter partisan politics that somehow twists financial reform as anti-American and pro-Wall Street. Banks cannot be allowed to gamble with depositor’s money. Not only do they gamble but also their losses are shared by the American public. The heads-we-win, tails-you-lose attitude in Wall Street needs to be reversed. There is a conflict of interest when Goldman Sachs can profit when their clients lose billions of dollars. However, the actual conflicting proprietary trading is perfectly legal and common under the current rules. What Goldman Sachs failed to do was disclose whether John Paulson—the person who picked the investments for the CDO in question—stood to benefit from its failure.

To accompany Senator Dodd’s version of the financial reform bill, Senator Blanche Lincoln’s derivatives bill in the Senate Agricultural Committee works towards a similar end to restore banking to basics by requiring derivative trading to take place on an open exchange and denying FDIC coverage of deposits by banks that trade these exotic securities. Derivatives—which essentially are bets on the price of something—can serve some purpose to hedge against risk, however. For example, farmers depend on futures to ensure stability in crop prices. But, derivatives comprise $600 trillion dollars of the US economy, and their trading is largely done behind closed doors. Often times, they represent an unnecessary gamble that serves no purpose to the rest of society. These need to be regulated.

High finance is a messy and a widely misunderstood industry. Its function in the world economy has become so incredibly complicated that regulators fail to understand what is destructive and what is beneficial for the rest of the country. Despite what some religious teachings may say, earning interest and common banking is now traditionally accepted by society and needed. However, gambling with the economy and spreading losses to people who had no part in the investment are simply unacceptable.

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