Yesterday, the Senate Committee on Banking, Housing, and Urban Affairs held ahearing entitled “Prohibiting Certain High-Risk Investment Activities by Banks and Bank Holding Companies.” The hearing focused on the Obama Administration's recent proposal to limit the size and scope of banks and other financial institutions. Specifically, the President’s proposal would (i) prohibit banks or bank holding companies from “own[ing], invest[ing] in or sponsor[ing] a hedge fund or a private equity fund, or proprietary trading operation unrelated to servicing customers for its own profit” and (ii) “place broader limits on the excessive growth of the market share of liabilities at the largest financial firms.”

Testifying before the committee were the following witnesses:

  • Paul Volcker, Chairman, President’s Economic Recovery Advisory Board
  • Neal S. Wolin, Deputy Secretary, U.S. Department of the Treasury

Mr. Volker expressed his support for the Obama Administration’s proposal to limit “certain proprietary and more speculative” activities of commercial banks, referred to by some as “the Volker rule.” He noted the importance of a “safety net” of deposit insurance for commercial banks, but stressed that taxpayers should not have to provide this “safety net” to support “essentially proprietary and speculative activities” of the banks. He also acknowledged the “strong conflicts of interest inherent in the participation of commercial banking organizations in proprietary or private investment activity.” According to Volker, “when the bank itself is … trading for its own account, it will almost inevitably find itself, consciously or inadvertently, acting at cross purposes to the interests of an unrelated commercial customer of a bank.”

In addition to the restrictions on commercial banks, Mr. Volker stressed the importance of creating the “authority to regulate systemically important non-bank financial institutions” and a new “resolution authority” that would “take control of a major financial institution on the brink of failure” and “arrange an orderly liquidation or merger.” According to Volker, the resolution authority would provide a means of “euthanasia,” rather than “recovery,” for the financial institution.

Mr. Wolin echoed Volker’s support for the proposals, stating that “the recent proposals compliment the much broader set of reforms proposed by the Administration in June [and] passed by the House in December.” He described the proprietary activities that the proposal would limit as “volatile and high risk” and stressed the importance of separating these activities from the “business of banking.” He also acknowledged the need to “end … the dangerous perception that any financial institution is ‘Too Big to Fail.’” In response to questions from members of the Committee, Mr Wolin stressed that even if a financial firm decided to discontinue its commercial banking business, it would still “be subject to robust consolidated supervision and regulation – including strong capital and liquidity requirements.”

While all of the members of the Committee acknowledged the importance of protecting the financial system, some questioned the necessity and impact of the recent proposal. Senator Richard Shelby (R-AL), the ranking member of the Committee, pointed to a lack of evidence that proprietary trading created the recent financial problems and questioned whether prohibiting proprietary trading would “protect the financial system” in the future. Similarly, Senator Bob Corker (R-TN) argued that no bank holding companies with commercial banks had “any material problems” with proprietary trading during the most recent financial crisis. Senator Mike Johanns (R-NE) expressed concern that the “Volker rule” would not have helped the problems with AIG or Lehman Brothers and that the recent proposal would expand financial reform “beyond where it should be.”

Members were also interested in the potential acceptance of the proposal by the international regulatory community. Mr. Wolin noted that the proposals are consistent with the principles expressed by the G-20 leaders and that the Administration is currently working with the international community. Although he questioned the potential international acceptance of the proposal, Chairman Christopher Dodd (D-CT) stressed the importance of U.S. leadership in this area, noting that it would “raise significantly the possibility that others will follow.”

Certain members of the Committee expressed support for the proposal, but also wanted more information on the details of implementation. Senator Charles Schumer (D-NY) generally “agree[d] with the premise of the proposal,” but also praised certain aspects of the Canadian regulatory system and its methods for protecting against risk. Senator Robert Menendez (D-NJ) stressed the importance of acting now and noted that “customer deposits [should not] be a part of the speculative nature that can create a crisis.” Members also questioned the panel regarding the definition of proprietary trading and how the proposal’s limitations would be enforced by the regulators.

In conclusion, Chairman Dodd stressed the need to make progress on reform legislation this year and criticized the lateness of the proposal. Although he generally supported the “idea” of the proposal, he also stated that “we don’t want to be in a position where we end up doing nothing, because we are trying to do too much.” Mr. Wolin acknowledged the Chairman’s concerns.