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Managing Wall Street meltdowns

There are better ways to prevent future bailouts than what Obama has proposed.

January 23, 2010

How many initiatives can President Obama justify by pointing to the public's outrage over excessive bank bonuses? Last week the administration called on Congress to tax big banks, insurance companies and brokers to recoup what taxpayers spent bailing out the financial markets. This week the administration added two more items to its legislative to-do list: a cap on the size of banks, and a ban on certain types of investing. Although an argument can be made for the proposals, they go further than necessary to protect taxpayers against the risk of future bailouts. And that's the real goal, even if it's less politically satisfying than hammering banks.

The steps that Obama outlined this week are responses to Wall Street's near-death experience in 2008, which prompted Congress and the Federal Reserve to commit staggering sums to rescuing the credit markets. The administration already has proposed overhauling the financial regulatory system to guard against a future meltdown, and many of its ideas are contained in bills that are moving through Congress. On Thursday, though, Obama upped the ante by calling for the two new restraints. One would limit how much of the industry's total liabilities any one company could take on, in effect capping how big a bank could become. The other would prohibit a commercial bank from owning or investing in a hedge fund or buyout firm, or from trading securities purely for its own profit.

We welcome efforts to deter companies from growing into too-big-to-fail behemoths, but it would be better to do so by imposing higher reserve requirements and other safeguards that can lead investors, lenders and borrowers to shy away from excessively large banks. The administration's proposal would have the government set an as-yet unspecified cap in lieu of letting markets make that judgment on a daily basis.

We also encourage Congress and federal regulators to come up with more effective ways to separate bank holding companies' traditional banking practices from the more lucrative and riskier practices of their subsidiaries on Wall Street. If a company such as Goldman Sachs or Citigroup wants to engage in both types of activity, it's entirely appropriate to impose tougher limits on what its investment arm can do, along with rules that make risks more transparent to regulators and shareholders. The barrier Obama has proposed, though, wouldn't solve the problems at the root of the last meltdown. It's worth remembering that the 2008 collapse was made possible by an epic failure by banks and lenders to make loans that were likely to be repaid. Taking away the banks' proprietary trading desks without confronting this breakdown in risk management won't avert the next bailout.

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