Obama’s Misguided Proposals for Financial Institutions

In a speech given Thursday, President Obama demonized financial institutions while failing to acknowledge the role of the government in creating the conditions that led to such poor behavior:

[R]ules … allowed firms to act contrary to the interests of customers; to conceal their exposure to debt through complex financial dealings; to benefit from taxpayer-insured deposits while making speculative investments; and to take on risks so vast that they posed threats to the entire system.

On Obama’s first point, it is worth noting that in a free market, when a firm acts “contrary to the interests of [its] customers,” it loses those customers — and perhaps more, if fraud is involved. However, we do not have a free market in banking or finance. Government entities such as the Federal Deposit Insurance Corporation (FDIC), the U.S. Securities and Exchange Commission (SEC), and the Federal Reserve have destroyed an essential element of the free market (among many others):  consumer vigilance.

The vast majority of Americans are not concerned with the exposure of their bank “to debt through complex financial dealings.” After all, if their bank goes bankrupt, there is no need to worry:  The FDIC will return their money to them. The SEC, on the other hand, instills a false sense of confidence in investors. Investors likely would have performed an appropriate amount of due diligence on Bernie Madoff had the SEC not implied he was reputable.

Obama’s second point falls flat on its face as well. The fact that firms “benefit from taxpayer-insured deposits while making speculative investments” is the direct result of fractional reserve banking in which the Federal Reserve acts as the lender of last resort. Obama should have mentioned that banks are only required to keep 10% of their deposits on hand and are therefore capable of pursuing “speculative investments” with their customer’s money. None of this would be possible in a free market — fractional reserve banking would cease to exist because it is inherently unstable.

One of Obama’s proposed reforms is to “close loopholes that allowed big financial firms to trade risky financial products like credit defaults swaps and other derivatives without oversight.” Trusting the government to regulate these products is hopeless. The SEC couldn’t even identify the largest ponzi scheme in the history of the world, “despite receiving six ‘substantive complaints that raised significant red flags’.” (I’m not counting government-sponsored ponzi schemes like Social Security.)

Obama’s most concerning statement is that “banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations.” Although I do not like the idea of banks engaging in such activities, I am much more concerned by the idea of the government dictating to banks what they can and cannot do with the money they have on deposit. Banks should answer to their customers, not the government.

Obama concluded by saying that “we simply cannot accept a system in which hedge funds or private equity firms inside banks can place huge, risky bets that are subsidized by taxpayers and that could pose a conflict of interest.”

I agree; however, more government control is not the answer. Ending fractional reserve banking and the Federal Reserve is.

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