Donald Trump’s Plan to Reform the US Banking Sector Deserves Plaudits

Image of two young businessmen using touchpad at meeting

Another day, another record high over on Wall Street. The Dow and S&P 500 just keep marching higher. It’s all getting a bit boring…

Where’s the excitement, the tension, the fear? It looks like the only thing that can take this market down is some good old strong economic growth. That’s about the only thing that would get central bankers to pull their heads in and raise interest rates.

New highs in stocks, and a lack of a fresh crisis (for this week, anyway), should see gold continue to correct lower. It’s now around US$1,315 an ounce, down around US$20 an ounce overnight.

That’s not surprising. I’ve been talking about a correction playing out, and have just published a special report on how to take advantage of it. You can access it here.

So what else is happening?

Break Up the Banks

Well, Donald Trump, aka Biff Tannen, just got the nod as Republican Presidential candidate. He’ll face off against Hillary Clinton in what is sure to be one of the most bitterly contested US elections in memory.

Now, I’ve got no time for either candidate. Who is the lesser evil? I really don’t know. Trump’s flaws are there for all to see. Clinton’s are hidden, disguised and pushed out of view by wads of cash.

But something Trump said recently piqued my interest. He wants to break up the big banks. From the Financial Review:

Wall Street has descended into a state of shock after Donald Trump’s campaign revealed the Republican presumptive presidential nominee would push for the reinstatement of the Glass-Steagall banking law to effectively break up the big banks.

Mr Trump’s campaign manager, Paul Manafort, said at the Republican National Convention in Cleveland on Monday that the party’s official policy platform would advocate a return of the Depression-era law, which was repealed under President Bill Clinton in 1999.

This is a big deal, although Wall Street isn’t really concerned at this point. The big banks have Hillary all wrapped up, and no one seriously thinks Trump will get elected.

But his proposal is probably one of the better reforms I have heard for some time.

For the past few decades, the financial system has lurched from crisis to crisis. Central banks have provided the system with extraordinary support, and taxpayers in nations all around the world, US included, have bailed their banks out after they got into trouble.

Much of the build-up of risk in the financial system in recent years is due to the repeal of the Glass-Steagall act in 1999.

The act came about in the aftermath of the Great Depression. Put simply, the Glass-Steagall act separated traditional retail and commercial banking from the higher risk investment and trading activities undertaken by investment banks.

The repeal of the act in 1999 (by none other than Bill Clinton) paved the way for mega mergers in the industry. It created financial behemoths that were ‘too big to fail’.

It’s one of the key problems in the current-day financial industry. Banks are too big to fail, which creates a huge and destabilising asymmetric risk situation in the financial system.

That is, bankers know they can take big risks and take all the spoils if things work out. But if it all goes pear shaped, they’ll get a taxpayer funded bailout, meaning their downside is protected.

Breaking up the banks into smaller entities, as Trump proposes, is an eminently sensible idea. I’m not suggesting that such an arrangement would prevent future crises. But it would remove some of the asymmetric risk that currently exists, ensuring that the risk/reward trade-off works as the laws of capitalism intended it to.

A healthy financial system is one where there are lots of players competing, not one that is concentrated with massive companies that must be protected because of their very size.

And if banks do get either implicit or explicit backing from taxpayers, why don’t they pay a fee for this support?

The history of modern day banking is replete with examples of bankers squeezing as much as they can from governments or central banks when support is needed, playing the ‘systemically important’ card. Yet they absolutely refuse to concede that they should bear a cost for this support.

Banks ARE important. They play a crucial role in providing credit to households and businesses. But if they do so recklessly, shareholders and other creditors should take a hit. It shouldn’t be up to taxpayers to foot the bill.

If taxpayers are the implicit backers of troubled banks, the banks should pay a fee for it. As it stands, they’re getting a free ride, and no doubt loving it.

Given the prospects of a continuing free ride in the shape of more rate cuts from the RBA, and the general increase in risk appetite globally, bank shares have all performed well in recent weeks. They all bounced strongly from close to long term support levels.

But still, as the one-year chart of banking sector barometer Commonwealth Bank [ASX:CBA] shows, the sector doesn’t look too exciting. CBA is going nowhere. And while the recent rally is encouraging, it occurred on a slight drop in volume, which tells you there isn’t a whole bunch of enthusiasm towards the banks right now.

Source: BigCharts
[Click to enlarge]

To become more positive on the sector, I’d like to see the share price trade above the May highs, around $79. That’s not too far off. But recent history says you might see another correction before then.

That’s because bank earnings remain under pressure. Only a desperate lunge for yield and ignorance of risks would justify much higher prices from here.

But given what’s going on elsewhere around the world, such a move would not surprise me at all.

Ah…investing in a world of centrally planned economies and markets is not for the fainthearted!


Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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