President Obama wants to rein in the size of banks by eliminating proprietary trading in investment banks. Reactions on Wall Street and in Washington have been varied since President Obama announced his proposal to reduce the size of investment banks. We hear him deriding proprietary trading as “gambling with taxpayer money”, but what exactly does that mean?

Trading at an investment bank comes in two forms: proprietary trading and flow trading. Flow trading is mainly buying and selling positions on behalf of customers (usually institutional investors such as hedge funds or other companies).

Proprietary trading is when a trader invests in the markets using his own firm’s money. The problem President Obama has with this is that he says the money that is used for this is from the taxpayers’ money since the government is bailing out so many investment banks using capital from tax. However, is that really the case? And why does proprietary trading mean betting?

Another argument is that sometimes proprietary trading can be seen as lending (since they are buying certain asset classes). Restricting this form of lending can be bad to the financial systems. According to a former Federal Reserve President who has studied bank bailouts, the right incentives as well as market discipline should solve the problem. His evidence is that when there is an incentive for uninsured creditors to look more closely at banking activities and charge them higher prices for higher risks, the firms will respond.

Regulators should confidently tell businesses that there will be no more bailouts, instead of restricting ‘proprietary trading all together.’ If the communicate this message effectively, banks will respond knowing that there is no second chance.