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Take stock of Wall Street

india Updated: Jan 24, 2010 21:56 IST

US President Barack Obama joins other heads of governments in the West trying to tame the animal instincts that lend capitalism its unique vigour. By banning deposit-taking banks from propriety trading, he is brutally curbing their risk-taking ability. Regulation in mature capitalist economies has settled on calibrating risk with capital provisioning, not by denying access to financial innovation. Mr Obama’s proposal will not only be difficult to implement because banking functions are fiendishly intertwined today but also it does not meet the larger regulatory goal of ring-fencing the financial system — and the economy beyond — from excessively risky behaviour by individual banks. Both these aims are better served by the Basel II rules, which came into force in Europe and Japan last year and will take effect in the US in 2012, that boost the amount of capital banks have to hold against private equity investments.

US banks have of their own been reducing private equity investments as leveraged buyout deals dry up. Banks provide 9 per cent of the capital invested in US private equity funds, most of which is capital managed on behalf of clients. Internal hedge funds and private equity investments make sense for banks because of the trading, underwriting, and advisory revenue they provide, not extraordinary returns. The main benefit is it opens the door to clients from private equity groups. The most likely outcome of

Mr Obama’s proposal is that funds currently owned by banks will be spun off as independent entities, pushing more money into dark pools that are more difficult to regulate.

The G-20, in a rare display of collective regulatory overhaul, has made some eminently actionable suggestions. One, alongside rules for individual agents that most economies have in place, is to have rules for the market overall, to be scalable as the situation demands. Essentially, macro-regulation as a supplement to everyday micro-regulation. Two, the market’s appetite for risk swings wildly between boom and bust and the reins should be tightened when the animal spirits are high. By building up prudential capital buffers during the benign phase of an economic cycle, when it’s easier and cheaper to do so, financial institutions can enter more challenging times from a stronger position. Mr Obama need not have broken ranks with the rest of the world in trying to fix a problem that affects us all.