Taking on the banks

President Obama yesterday laid out the main themes of his initiatives to curb the banking sector. Forget that the timing was chosen to position this issue as the main theme for the US mid-term elections. Forget that the best opportunity to have taken the fight to the banks was a year ago when the banks survival was dependent on government support.

It is good news that President Obama yesterday in a well-covered speech finally came clear about several of the issues that became clear in the aftermath of the banking crisis.

It is good news for many reasons. One is that the debate has now moved into very public spot, where it is much less likely that the banks and their lobbyists can exert discrete but powerful influence. Bank chiefs who award themselves 100's of millions of dollars in bonuses do not exactly have a lot of support in the public. It is good news as it is now clear that the Obama administration is doing something about one of the main moral hazard issues in modern capitalism: that banks have been allowed to grow to a size where letting them fail is not a political option.

It is also a stunning reversal of fortunes for former US central banker Paul A Volcker, who had been entirely marginalised by the Obama team. Volcker has been vocal in his criticism of the banks and their greedy practices and recently stated that the banks' most important contribution to the modern society in the past three decades was the ATM. Volcker has become an ardent proponent of introducing legislation effectively breaking banks into smaller specialised units, who each will have to manage their own risk.

Proposal now forwarded by the Obama administration indicate exactly that kind of thinking. Otherwise, the ideas presented were not particularly well thought out. The idea to prevent the banks from having proprietary trading appears to be a populistic element, mainly driven by Obama's attempt to tap into popular outrage over the astronomical bonuses handed out for 2009.

It does not matter that the ideas are unclear as an eventual law package will have little to do with the initial proposal anyway. What is important is that the Obama administration is now promoting the banks to the centre stage of policy making.

The financial markets still have not got it. The banking sector had grown out of proportion in the past 20 years and made up nearly 20 percent of the major indices while not bringing much to society except for a culture of greed and neglect of basic principles for handling of risk. Plus – of course – the bank rescue package that it will take a generation to pay for.

Apart from introducing regulatory reforms forcing a new and far more prudent approach to risk, there is no other way than to cut the banks down to a size where no bank is too big to fail. It will mean that the banking sector becomes less profitable, and through the iron laws of capitalism, it will mean that the sector will attract less capital.

If the Obama administration is successful in this new initiative, it will have a huge impact as it will be copied by governments elsewhere. For the markets, it means that the financial sector will shrink and that the expectation that banks should return the glory of yesterday is unrealistic.

For the markets and for asset managers across the globe, it is worthwhile following this debate very closely. If everything goes as Obama now indicates, we may well see the relative size of the banks in the various indices cut by more than half over the coming years.