FINANCIAL CRISIS

Financial Crisis

Financial Crisis

Part a:

President Obama proposed two new restrictions designed to limit the size and scope of financial institutions. One restriction would limit the scope of a financial institution's activities by barring any insured depository institution, or any financial firm which owns an insured depository institution, from owning, investing in or sponsoring a hedge fund or private equity fund and from engaging in proprietary trading operations unrelated to serving the institution's customers. The proposal did not provide a definition of proprietary trading, which some commentators have asserted may be difficult to distinguish from trading that relates to business conducted for customers. The other restriction would limit the size of a financial institution through a cap on an institution's nondeposit liabilities (Berger Allen 2006).

Depository institutions are currently prevented from acquiring another depository institution if such transaction would result in the resulting institution holding more than 10 percent of aggregate U.S.-insured deposits. Financial institutions are allowed to exceed the 10 percent limitation through organic growth. The proposed restriction would supplement the deposit cap and would include such liabilities as non-insured deposits and wholesale funding. The level of the proposed cap has not yet been determined. This restriction is designed to limit the future growth of the largest U.S. financial institutions. The President's proposal was heavily influenced by former FRB Chairman Paul Volcker, so much so that the President referred to the restriction on proprietary trading as the “Volcker Rule.”

Many of the details of the proposal remain unclear, and some have asserted that it may prove to be unworkable. The President asked Congress to incorporate these restrictions into its financial regulatory reform legislation. In December 2009, the House of Representatives passed a comprehensive regulatory reform bill which contained broad authority to limit the size and scope of firms that pose a grave threat to the U.S. economy and financial stability. For more on the House bill, please see the December 15, 2009 Alert.

Financial markets and institutions exist to overcome the effects of information asymmetries and transaction costs that prevent the direct pooling and investment of society's savings. They mobilize savings and provide payments services that facilitate the exchange of goods and services. In addition, they produce and process information about investors and investment projects to guide the allocation of funds, monitor and govern investments, and help diversify, transform, and manage risk.1 When they work well they provide opportunities for all market participants to take advantage of the best investments by channeling funds to their most productive uses, hence boosting growth, improving income distribution, and reducing poverty. When they do not work well growth opportunities are missed, inequalities persist, and in extreme cases, there can be costly crises.

Until recently econometric research on the performance of formal financial systems around the world has focused mainly on their depth, efficiency, and stability. Cross-country regressions have shown financial depth to be not only pro-growth but also pro-poor: economies with better developed financial systems experience faster drops in income inequality and faster reductions ...