Forbes.com

By Rob Nichols

In New York Thursday President Obama called for the enactment of much-needed financial regulatory reform and modernization. The Financial Services Forum, a nonpartisan financial and economic policy organization comprising the CEOs of 19 of the largest financial institutions operating in the U.S., strongly agrees with the president on the need for sensible, thoughtful reform that preserves our position as a global financial leader.

To maintain a position of financial and economic leadership, the United States needs a 21st-century framework of financial supervision that protects the interests of depositors, investors, consumers and policy holders; ensures the safety and soundness of financial institutions; ensures financial stability; and ensures an effective and competitive financial marketplace. Bipartisan reform will also bring much-needed certainty to our capital and credit markets, helping to fuel our economy and create jobs.

While the forum supports the overwhelming majority of what Congress and the administration has proposed, a few areas of the bill require more focus and attention to avoid potentially severe unintended consequences affecting economic growth, job creation and our nation's international competitiveness.

For example, on Jan. 21 President Obama announced a proposal to ban commercial banking companies from engaging in proprietary trading, hedge fund or private equity activities. The president called the proposal the "Volcker rule" after former Federal Reserve Chairman Paul Volcker. More recently, Senator Blanche Lincoln, D-Ark., chairman of the Senate Agriculture Committee, has passed out of the committee legislation that would require banking companies to divest of their derivatives trading businesses.

A proper policy response to the financial crisis depends on an accurate diagnosis of its causes. Trading, proprietary or otherwise, did not cause the financial crisis. The Volcker rule, and proposals that would ban banking companies from dealing in derivatives, misdiagnose the root causes of the crisis and would needlessly undermine the international competitiveness of the U.S. financial system to the detriment of American businesses, consumers, savers and investors.

Just this week National Economic Council Director Larry Summers told PBS NewsHour's Jim Lehrer:

Most observers who study this believe that to try to break banks up into a lot of little pieces would hurt our ability to serve large companies and hurt the competitiveness of the United States. ... They believe that it would actually make us less stable, because the individual banks would be less diversified and therefore at greater risk of failing, because they would haven't profits in one area to turn to when a different area got in trouble. And most observers believe that dealing with the simultaneous failure of many small institutions would actually generate more need for bailouts and reliance on taxpayers than the current economic environment.

The financial crisis was not a "risky trading" crisis--it was a "poor lending" crisis. The value of mortgage-backed securities plummeted in value not because they were traded, but because too many of the mortgages that backed those securities fell into foreclosure.

A number of members of Congress have talked about protecting "plain vanilla banking" from risky trading, as if banking is lower-risk or even without risk. Not only does lending entail risk, lending is arguably the riskiest activity any financial entity can engage in. Last year 140 banks failed, the highest rate of failure since 1992. Another 56 banks have failed so far this year, an even faster pace of failure than last year. Each of the 196 banks that have failed since January 2009 failed because of loan losses, not one because of trading.

Trading activities in fact can help make banks less risky and more stable by diversifying the company's activities and revenue streams. Institutions that have a diverse mix of businesses--lending, securities underwriting and trading--are more stable than those whose earnings and stability depend one asset class or one line of business.

In February European finance ministers indicated that Volcker rule restrictions would likely violate European Union universal banking laws. Because it appears other parts of the world will not ban banking companies from proprietary trading, hedge fund,and private equity activities, imposing the ban in the U.S. would put firms operating here at a significant disadvantage.

Also, because there is a robust market for the trading and market-making services provided by large banking companies--which are heavily regulated--banning banking companies from these activities will only drive them into unregulated, or far less regulated, parts of the financial system, increasing systemic risk and undermining the fundamental objective of regulatory reform.

Rather than arbitrarily prohibiting perfectly legitimate financial activities, a better and more appropriate role for government is to work with the financial industry to improve the quality and effectiveness of risk management, internal controls, corporate governance and capitalization--and the quality of official supervision.

We thank the president for his dedication to addressing these complex issues, and respectfully urge members of Congress to send a strong, bipartisan reform bill to his desk this year, and reject proposals that could harm U.S. competitiveness and eliminate jobs. The forum will continue to work with Congress and the administration for sensible financial regulatory reform.

Rob Nichols is the president and COO of the Financial Services Forum, which comprises the CEOs of 19 of the largest financial services institutions doing business in the U.S., including Citigroup, JPMorgan Chase, Bank of America, GE Capital and Goldman Sachs.