President Obama Proposes Legislation Prohibiting Financial Institutions Involvement with Hedge Funds

The Obama Administration has proposed new restrictions on the size and scope of banks and other financial institutions in order to rein in excessive risk taking and to protect taxpayers. President Obama joined former Fed Paul Volcker, former SEC Chair Bill Donaldson, House Financial Services Chair Barney Frank; and Senate Banking Committee Chair Chris Dodd in announcing the proposal, which would strengthen the comprehensive financial reform package that is already moving through Congress.

Under the proposal, no bank or financial institution that contains a bank would be able to 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. The President also announced a new proposal to limit the consolidation of the financial sector. The proposal would place broader limits on the excessive growth of the market share of liabilities at the largest financial firms.

The proposal embraces an idea earlier set forth by Mr. Volcker that banking organizations should be prohibited from sponsoring and capitalizing hedge funds or private equity funds, and there should be strict regulation, with strong capital and collateral requirements, on proprietary securities and derivatives trading. In remarks last year at the Association for Corporate Growth, he noted that extensive participation in the impersonal, transaction-oriented capital market is not an intrinsic part of commercial banking.In his view, substantial involvement in heavily leveraged finance and heavy proprietary trading almost inevitably entails substantial risk. It also adds a layer of complexity that is challenging for management and poses insidious, unmanageable conflicts of interest with customer relationships in a banking organization.

While acknowledging that hedge funds and other non-banking institutions have played an essential and increasing role in the financial markets, he observed that given the lessons of the recent past the federal oversight and regulation of hedge funds is inevitable and appropriate. The registration of hedge funds and equity funds is a minimal step, he said, and the reporting to authorities of their business models and large positions is appropriate. Collateral requirements and leverage restrictions, with accompanying official oversight, of the largest and systemically significant individual institutions are also needed.

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