There are two key aspects to President Obama’s banking reform:

1) It attempts to address the ‘too big to fail’ debate: Obama wants to place size limits on banks (although it is still unclear what these are). This should create a wave of divestments and carve-outs in the banking industry.

2) To break up the banks, Obama’s criterion is to reduce a number of their high-risk activities: he plans to impose a ban on proprietary trading and a ban on the ownership, investment or sponsorship of hedge funds and private equity.

Ultimately, Obama is forcing the banks to choose between deposit-taking and high-risk activities. Those banks which want to continue engaging in high-risk activities have to sell their retail banking assets and lose access to emergency federal funding.

The main pro of the reform is precisely this denial of access of high-risk players to a federal bailout in case things go wrong. Through this, Obama addresses the moral hazard of bailouts.

Yet the cons of the reform are noteworthy:

1) Restrictions on prop trading could further depress liquidity.

2) Restrictions on private equity funding at a time when bank credit is scarce make little sense, especially as private equity is an investment activity with a long-term horizon, unlike prop trading.

3) The reform isolates risk from economic activity, which is an oxymoron. Risk is the flip side of reward/incentives, without which an economy cannot function.

The Impact On Banks, Private Equity, And M&A

However, the reform’s impact on banks is still unclear, as it is still very general and vague. Its final impact will depend on:

1) The definition of prop trading. While in theory, prop trading on average only represents 1% of bank revenues, it is hard to distinguish it from client business, as the latter transactions still find their way in banks’ balance sheets, with banks holding positions for their clients.

2) The definition of private equity investment. Similarly, while a number of banks have sizeable private equity interests, it can be argued that they are investing in them for their clients.

The impact on private equity should not be too strong, in so far as banks only account for 9% of the capital invested in private equity in the US. The impact should be greater on the leveraged buyout (LBO) segment of private equity, as banks tend to find it particularly lucrative to co-invest with LBO funds and give them access to leveraged loans.

The impact on M&A should be significant, especially as far as the large US integrated banks are concerned. JP Morgan and Bank of America should top the list of banks forced to divest.