Barack Obama's proposal to split up banks and limit their size, while they have drawn some praise, have so far prompted a nervous reaction from the wealth and investment management world.

US president Barack Obama’s proposal to split up the country’s banks and cap their size has drawn a nervous reaction from wealth and investment commentators, with some predicting such measures could harm sectors such as private equity on a global scale. 

It is as yet unclear whether other nations will follow suit, although it appears that the UK Conservative Party, which could win the next UK national elections to be held by early summer, is in favour of a similar move.

The US president’s proposals, designed to prevent another financial crisis, were announced in the week that the ruling Democrat Party in the US suffered a humiliating Senate defeat in its traditional bedrock region of the northeast, losing a seat once held by Ted Kennedy to the Republicans.

Last week's defeat in Massachusetts has arguably encouraged Mr Obama to focus on reforming banks as a way of reclaiming the political agenda. The proposals triggered a sell-off to the US stock market when they were announced last Thursday.

Simply put, Mr Obama intends, in part, to return the banking industry back to the regulatory climate in which deposit-taking banking and investment banking were kept apart by legal firewalls laid down by the Glass-Steagall Act 1932. These regulations were scrapped by the Bill Clinton administration in 1999.

The proposal could – depending on how it is enacted – force banks to offload activities such as hedge fund investing, private equity, and derivatives trading. Such activities have been blamed by some commentators and policymakers for fuelling the credit crisis and endangering the deposits of ordinary bank customers.

Ironically, the mega-mergers inked during the height of the financial turmoil, such as the purchase by Barclays of part of bankrupt Lehman Brothers, or the purchase of debt-ridden Merrill Lynch by Bank of America, might not have been allowed under a revived Glass-Steagall regime. While the causes of previous crises always have their specific factors, it is worth nothing that the pre-1999 regulatory system did not prevent all financial blowups. There is the case, for example, of the massive losses sustained by the US savings and loan industry in the 1980s. In the UK, for example, mortgage lender Northern Rock, which nearly collapsed and had to be bailed out by the taxpayer, did not have an investment banking trading arm.

There is another paradox. If the Obama proposals do become law, they may encourage wealth managers that are parts of big, integrated banks to move away from using the in-house products from their investment banking sister firms. This would buck a current trend. Last week, Scorpio Partnership, the consultancy, found in a survey that more investors were turning to in-house products, due to concerns about the quality of services provided by external firms.

Another issue, which is so far unclear, is how US banking groups operating outside their home territory would be affected by such proposals, or how they would affect any foreign firms working in the US.

Not very impressed

Robert Ellis, a US wealth management consultant at Novarica, was unimpressed by the motivation and general thrust of the Obama proposals, although he was supportive of some of the ideas.

“Welcome to the world of political economy, where politics trumps the economy. In the US, it is more important to sound like you are doing something, like limiting banks abilities in certain areas (which I mostly agree with, by the way) as opposed to real problems like unemployment and economic bubbles from cheap money,” he said.

“As far as the wealth management industry in banks is concerned, I see few implications from the most recent proposals. Wealth management mostly resides on the retail side of the house, not the proprietary or prime broker side. Wealth management is full of licensed people who are paid to manage client assets, not gamble with them,” Mr Ellis said.

However, he reckons that as far as wealth management products are concerned, the Obama proposals should be positive. “Proprietary trading, through its unholy tools such as flash trading (legalized front-running), dark pools, securities lending, etc, all of which transfer wealth from the retail public to overpaid professionals, will get fewer participants,” he said.

Andrew Bradshaw, partner at specialist pension solicitors Sacker & Partners, said pension funds will be concerned about the impact of such proposals on the hedge funds and private equity funds that might be affected.

“Pension funds that have invested significant amounts in these funds will be particularly concerned about the implications of any changes to their ownership structure going forward,” he said.

Private equity worries

Banks, which have been big conduits for client funds into private equity investments in recent years, will have to radically rethink how they place client money into such investments, causing serious disruption, according to Preqin, the research firm specialising in private equity trends.

“It is important to note that any effects of this proposal would also be felt further afield, with many US institutions also investing in European and Asian funds. It would also affect the many European investors in funds managed by US banking institutions,” it said.

To underscore what might be at stake, Preqin points out that US banking institutions managing private equity funds and fund of funds have raised a total of 60 funds since 2006, with a total value of over $80 billion, while banks have a total of $50 billion in private equity available capital.

Although many banks have spun out their merchant banking operations in recent years, there remain some significant players in this market. The most prolific banks in this area include Goldman Sachs, Credit Suisse, Morgan Stanley and Citigroup, the report said.

Banks account for 5 per cent of private equity investors in the US by number, and represent around 9 per cent of the capital invested in the asset class. There are 16 banks with fund of funds divisions currently managing private equity investments worth $94 billion.

Hundreds of limited partners in funds of funds managed by US banking institutions could also be affected by the proposal, the report said.

Hedge funds

As for hedge funds, US banks are relatively small direct investors in hedge funds, representing 0.9 per cent, or about $10 billion of the total capital coming from US investors.

“Although the full implications of Mr Obama’s statement remain unclear, the potential disruption that such widespread reform could bring to the alternatives industry is significant, and could affect hundreds of banking institutions in the US investing in alternatives,” said Tim Friedman, Preqin spokesperson.

“Furthermore, there would be a knock-on effect for the hundreds of investors in funds and funds of funds managed by these firms. Although it could be argued that banks are ‘serving their own customers’, and would therefore be exempt, the situation is currently very unclear, with one possible outcome being a widespread spinning out of alternative assets divisions within banks,” he continued.

“Whatever role banks had in the financial crisis, one thing is clear: it was not the bank’s ownership of or investment in private equity and hedge funds that caused the problems,” he added.

The uncomfortable question that is raised by Mr Obama's proposals is whether such ideas, put forward by a now-embattled president amid a crisis, might lead to unexpected issues in the future.