PAUL VOLCKER TOWERS OVER THE NEW GLASS-STEAGALL / THE FINANCIAL TIMES ( VERY HIGHLY RECOMMENDED READING )

Paul Volcker towers over the new Glass-Steagall

January 21, 2010 5:09pm

Before Barack Obama said anything today about his second Glass-Steagall, the story was evident from who stood next to him, and who was banished down the row of public officials.

To President Obama’s right was “this tall guy”, the 6′ 7″ Paul Volcker, who has until today been a lone voice in his administration calling for structural reform on Wall Street. Further along was Tim Geitner, the Treasury secretary, who has until now resisted it in favour of tighter regulation.

If Mr Obama is serious, as he appears to be, he is enacting a reform that will strike at the heart of Goldman Sachs’ business model - a combination of advisory, financing and asset management, and co-investing of its own money alongside that of clients.

The question is whether these restrictions would apply to all bank holding companies - including Goldman and Morgan Stanley - or only to deposit-taking institutions.

If it is the latter, then Goldman and others would be able to get around it by divesting their deposit-taking subsidiaries. If it applies to bank holding companies, then they could not. In either case, banks such as J.P. Morgan face sweeping changes.

The “Volcker rule” is far more radical than simply stopping banks such as Goldman operating proprietary trading desks. Instead, it addresses conflicts of interest at the heart of Wall Street.

Indeed, when I suggested a radical reform along these very lines in October, I wrote:

The final step would be to force investment banks to halt pure proprietary trading and to divest their asset management arms. Everything from management of mutual and hedge funds to private equity would be done independently.

Investment banks such as Goldman would, of course, scream blue murder if they were told to shed asset management (although Morgan Stanley might well choose to be an asset manager rather than a bank) but it would have several benefits.

To start with, it would reduce the risk profile of investment banks by removing proprietary trading. They would still be taking capital risk in market-making but the high octane trading desks would be gone.

It would also end the conflicts of interest in investment banks managing an opaque cocktail of their own and other people’s money while simultaneously being advisers and financiers on private equity deals.

Last, it would create an asset management sector in which large firms could co-exist with hedge fund managers and even boutique proprietary trading desks (if they could raise the capital outside the fold of investment banks).

These could take whatever risks they chose with investors’ money, provided they were honest about it, and pay themselves what they could get away with. The government would know that these gamblers would bear their own losses.

Stand by for Wall Street screaming blue murder.