President Obama recently announced a new proposal that seeks to limit the size and activities of financial institutions.  The President called the proposal the “Volcker Rule” after former Federal Reserve Chairman Paul Volcker, who has called for separating commercial banking and proprietary trading activities.

While a detailed version of the proposal has not yet been released, according to President Obama’s announcement, the proposal would “ensure that no bank or financial institution that contains a bank will own, invest in, or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit,” and “limit the consolidation of our financial sector by placing broader limits on the excessive growth of the market share of liabilities at the largest financial firms.”

The proposals are misguided because they are based on a misdiagnosis of the causes of the financial crisis, and because they would needlessly undermine the effectiveness, profitability, and competitiveness of U.S. financial institutions.

Proprietary Trading Did Not Cause the Crisis

Trading – proprietary or otherwise – did not cause the financial crisis.  Poor lending has been the principal cause of virtually every financial crisis throughout history – including the most recent crisis.  Financial institutions and other investors sustained crippling losses after the value of mortgage-backed securities plummeted.  The value of those securities fell after it became clear that too many of the mortgages (loans) backing those securities were defaulting.

At a September 10^th, 2009 hearing before the Congressional Oversight Panel, Treasury Secretary Timothy Geithner stated in response to a question about the role of proprietary trading in causing the financial crisis: “Most of the losses that were material for the weak institutions – and the strong, relative to capital – did not come from those [proprietary trading] activities.  They came overwhelmingly from what I think you can fairly describe as classic extensions of credit.”

In an October 15, 2008 Op-Ed published in the Wall Street Journal, American Enterprise Institute fellow Peter Wallison agreed: “None of the investment banks that have gotten into trouble…were affiliated with commercial banks...[Moreover], the ability of…banks to diversify into non-banking activities has been a source of their strength.”

It should also be pointed out that several large, diversified financial holding companies served as instruments of stabilization and recovery during the crisis by absorbing other failing institutions.

Most fundamentally, all financial activities entail risk, and any financial activity – lending, trading, underwriting, insuring – is only as risky as the rigor and effectiveness of the risk management and control methodologies around that activity.  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 – rather than arbitrarily prohibiting perfectly legitimate financial activities.

Value of Large, Diversified Financial Institutions

Proposal to preemptively break up well-managed and well-capitalized financial institutions is also misguided.  The problem of “too-big-to-fail” is not that institutions are large; it is that there is currently no legal authority to wind down a financial conglomerate in an orderly way.  More effective supervision, coupled with the authority to seize and wind down large firms, is the appropriate remedy to “too-big-to-fail.”

Large institutions provide value to customers – in the sheer size of credits they can deliver, in the array of products and services they can provide, and their geographic reach – that smaller institutions simply cannot.  This unique economic value is particularly important to large, globally active clients and contributes directly to economic growth and job creation.  In addition, large institutions – active in many markets and many countries across the globe – have served to integrate global stock, bond, and foreign exchange markets, making those markets more modern, liquid and efficient.  Large, globally active financial institutions have also expanded the supply of credit and other financial services to emerging market economies, contributing importantly to the expansion of trade flows, opening foreign markets to U.S. goods and services and, therefore, contributing importantly to economic growth and job creation.

To be a global financial leader – which is surely in the interest of American businesses, workers, savers, and investors – the United States needs financial institutions of all sizes, business models, and areas of expertise.  Rather than undermining the effectiveness and profitability of U.S. financial institutions, policymakers should address the real causes of the financial crisis by providing for systemic supervision, the legal authority to resolve large and complex institutions, and working with the industry to improve risk management, internal controls, and capitalization.