“Restarting Financial Reform”
January 26, 2010, 3:00am

Editorial — The New York Times.

In calling for new limits on the size and activities of big banks, President Obama has given the effort to enact serious financial regulatory reform something it lacked: a rational starting point.

The premise of the White House’s earlier approach to reform was that behemoth multitasking banks were an immutable fact of life and the best way to cope with them was to ensure that their failures would not endanger the rest of the financial system. As a response to the worst financial crisis since the Great Depression, “make the world safe for giant banks” was unsatisfactory.

It ignored history, and suggested a devotion to the status quo that made real reform seem unlikely. It also ignored that large and complex banks are a problem long before they fail: an overgrown banking sector diverts resources from more productive uses and, in the process, amasses riches at the expense of everyone else. The entire country can see the evidence of that in stagnating wages, disappearing retirement savings, vanishing home equity and taxpayer-supported bonuses.

Mr. Obama’s new proposals begin to correct those problems. They would ban banks with federally insured deposits from making risky bets in the capital markets. And they would prevent the banks from owning, investing or sponsoring hedge funds and private equity funds. Mr. Obama has also called for new caps on the size of banks, to limit the damage that a failure could inflict and to promote healthy competition.

Affected banks would include giants like JPMorgan Chase, Bank of America and Citibank. Goldman Sachs and Morgan Stanley would also fall under the new rules because they were converted to bank holding companies during the crisis so they could qualify for help from the Federal Reserve. But if regulators allow them to drop their bank charters, they would escape the new rules.

The new proposals have yet to go through Congress, so it is not yet clear exactly how much they would restrict or shrink today’s banks. But it is clear that they could separate the casino of Wall Street from the banking system on which everyone relies.

That, in turn, would reassert the principle — lost through the bailouts — that the government does not support or stand behind Wall Street-style trading. The proposals would also enshrine in law the principle that the nation does not want and will counter outsized banks with huge concentrations of the nation’s financial assets. At the very least, a cap on size could stop a dismaying trend of big banks getting ever bigger and more powerful.

Of course, it’s not enough to be right on principle. But with core and credible principles reasserted and reflected in law, the other pillars of financial regulatory reform take on a coherence that has been missing.

There are several ways to pursue the bedrock principles of controlling size and risk, including higher capital requirements, the regulation of derivatives and the creation of an independent consumer financial protection agency. It is also imperative to develop a resolution authority that would force shareholders, creditors and the financial industry to bear the cost of failures, while precluding the government from rushing forward with bailouts.

Now that Mr. Obama has set the stage and committed to leading the effort, those and other crucial reforms may yet happen.