Do not mix banking with proprietary trading - this seems to be the message Obama administration wants to convey to big banks engaged in proprietary trading, i.e., collecting deposits from customers and conduct trading on bank’s name.

The new rules proposed by the administration are aimed at restricting their activities and thereby, their growth and size. This proposal is part of a series of well-calculated moves to rein in Wall Street. Under this, commercial banks are excluded from having any dealings with hedge funds and private-equity firms. This includes not only owning or investing in them, but also getting involved in advisory capacity.

Banks barred from customer-unrelated trading activities are the ones that are eligible for bailout packages in the form of low-interest loans from Federal Reserve Board during financial crises. This is also applicable to banks that enjoy risk protection through federal-deposit insurance. The big shots in this field are Goldman Sachs, J P Morgan Chase, Deutsche Bank, Merrill Lynch, Citibank and Bank of America.

This landmark decision is bound to shake the foundations of investment banking. The forced choice between banking and proprietary trading is expected to produce a major impact on the direction and volume of growth of such banks. Obama administration appears resolute on severing the unholy alliance between the two.

Let us analyze the reason for their affinity. Investment banks are firms that help other companies raise funds in the capital market with stocks and bonds. As they are required to create a market for these stocks and bonds to make the issue a success, the banks buy them to boost their liquidity. This practice is called proprietary trading.

Over time, this activity evolved. Now, the investment banks indulge in proprietary trading not only to provide liquidity to the stocks and bonds they promote, but also to rake in huge profits. The traders entrusted with trading activities on behalf of banks developed this art to levels unthought-of. This prompted the banks to utilize multiple trader desks to deal only in proprietary trading, making it a large-scale profit-making venture for banks. The profit generated is over and above that earned from its originally intended purpose of liquidity creation.

Proprietary trading is not without risks. Nevertheless, banks engage in this due to the enormous profits generated. Many big names in the investment-banking scene earn a considerable portion of their profit through proprietary trading. Herein lies the trouble.

Another proposal to restrict banks’ growth is to put a cap on their market share. As of now, banks have a ceiling of 10% of insured deposits in the country. The new proposal is to include non-insured deposits and assets in this limitation. The definition of assets is not yet known. This step is aimed at preventing concentration of financial industry markets within the grip of a handful of industry heavyweights.

All these proposals were prompted by the industry goings-on during the just receding economic slowdown, which left the US in shambles, to say the least. What irked the government is the fact that these large banks, which were on the verge of collapse due to the recessive effects and had to be bailed out with financial aids, turned in considerable profit with proprietary trading .

The Obama administration has already made its dissatisfaction known when it proposed a new fee on mammoth banks to recover the money it was forced to dole out to rescue them from crumbling.

Obama’s comment sums up the sentiment - “Never again will the American taxpayer be held hostage by a bank that is too big to fail.”

written by REI Circle (www.reicircle.com)