This is a fascinating and pivotal time to be following the banking system. Recent developments of system overhauls, increased regulation, new taxes and proposed restrictions on the core business lines of banking institutions will fundamentally change the fabric of our environment. While it appears that political motivation will certainly create more stringent guidelines and restrictions, it will almost certainly ignite some unintended consequences as well. Obama’s proposal to restrict the proprietary trading business of investment banks has been fueled by public outrage of investment banks’ ability to make trades that straddle both sides of any market. Goldman Sach’s proprietary trading position in 2007 showed that while the firm was one of the top underwriters of structured loan products throughout the housing and credit boom, at the time of the market collapse they also had a short position in the very same type of paper they were originating. While acting as a principal or as an agent on a trade are separate business activities involving different degrees of risk mitigation and capital commitments, in the public and political eye, it creates many questions as to the legitimacy of allowing those business lines to operate under one roof. Proprietary trading is when an investment bank’s traders actively buy and sell securities or other financial products for the benefit of the firm’s own account. This activity is sometimes done alongside clients, but can also be done independently. The internal “prop” desks often act similar to a hedge fund, employing strategies to capture market mispricing and arbitrage. Many investment banks also run separate hedge fund or private equity entities where they invest proprietary capital alongside their clients. It appears both of these are the areas where the bullets from Washington are aimed. Limiting internal hedge funds or proprietary trading business lines would certainly mitigate the risk that an investment bank is able to undertake, but does this really address the problems that were at heart of the 2008 financial crisis? Taking risk and managing that risk is what trading is all about. As well, having two sides to every trade is necessary for efficient market liquidity. Whether a trader is consistently profitable or not defines how good they are at placing bets and managing the risk they take. I agree that there were too many risks in the credit and housing markets concentrated in too few places. The remarkable problem was not that these bets went sour or risk wasn’t managed well, but rather that there were minimal consequences to go along with those mismanaged bets. Indeed Bear Stearns and Lehman Brothers felt the consequences of their overleveraged bets, but what about AIG, Fannie Mae or even General Motors? In this writer’s opinion, AIG was one of the most flagrantly mismanaged institutions at the heart of the crisis and is consequently running one of the biggest bailout tabs. AIG was allowed to grow and expand the financial services portion of their business, which was not only outside of their core insurance business practice, but was unhedged, mismanaged, and contributed to the total demise of the company. Unlike all of the major investment banks who have already repaid their TARP loans, AIG’s tab to the government still stands at $180 billion, which is approximately $1100 per American taxpayer. Eliminating proprietary trading activity within the nation’s big banks does nothing to address the excessive risk taken elsewhere in financial services or other areas of the economy. I understand the public ire at policy and corporate failures which is driving the current political backlash, but much of it is misguided and won’t do anything to prevent future calamities. The focus of any regulatory or reform efforts should not be in limiting specific business units, but rather in addressing the “too big to fail” conundrum. If there are implied guarantees that institutions are “too big to fail,” doesn’t that give organizations a much higher incentive to engage in risk-seeking activity? If the risk-taking pays off, the business will be highly profitable. If the risky business lines fail, the government will provide a low-cost backstop. Herein lies the heart of the problem. It’s not that banks are taking risk – that is the foundation of our capitalist and investment driven society. Offering loans or extending credit to individuals and/or corporations is inherently risky business (that consumers are currently begging for!!) and any capital provider should be appropriately compensated for taking credit risk. The problem is that with a governmental “too big to fail” backstop, there are no consequences for mismanaging or mispricing any economic risk that is taken. Running a diversified business mitigates a company’s overall risk profile and should lead to more stable earnings. Pulling away distinct business lines could have one the following consequences – either banks will contract capital committed to ancillary business units such as corporate or consumer lending because they can’t hedge these business lines, or they will seek out other market areas to take even larger risks in an attempt to make greater profits. As for the latter, as long as “too big to fail” is still in place, why wouldn't you make even bigger bets if there aren't any consequences?