A tl;dr on financial regulation.
If an institution is too big to fail, it is too big to exist!
It’s a common question this year–does Bernie Sanders know what he’s doing with finance and the economy? For starters, there’s this piece from the NYT arguing that despite appearances in an interview, Bernie does in fact have an idea of what’s going on. On the other hand, he’s drawn many criticisms for his policy proposals and their projected outcomes, and it’s not always clear he does understand how the system works. For example, he has supported the Audit the Fed bill in Congress, even though that movement is not about policing Wall Street, and has nothing to do with financial regulation–it has to do with targeting interest rates, and whether Congress should have oversight of that process.
But this post isn’t about Bernie (sorry?). It’s about whether we ought to break up the banks. Oh boy, financial regulation!
Seriously though, don’t you want to know how it works? How far we’ve come–and not–since the crisis?
Let’s start with a basic premise: a bank, no matter the size, exists to serve its customers and make a profit. Those customers may include you and other consumers, small companies, corporations, governments. Moreover, banks provide a crucial function in the modern economy: moving financial capital (moniez) to where it’s most efficiently used. A bank doesn’t engage in risky behavior (e.g. investing in toxic MBS) for the fun of it; it does it to make a profit, and maybe to provide money to someone who needs it–it just may not account for the effects it might have on someone else, or society, if the bet goes bad.
Though I was initially warm to the idea, and appreciate the effort Minneapolis Fed President Neel Kashkari has put into engaging the public, I’m less than convinced that breaking up the banks is the way to fix the financial system. Here’s a list of what I’m noticing:
- The big banks were not necessarily even the original problem.
Community banks and regional banks were failing on a large scale, too, and received bailouts. A lot of the medium-sized banks were failing, and in fact the largest were able to sustain some of the bad bets. As Michael Grunwald, who has worked with former Treasury secretary Geithner, puts it:
[The now-largest banks] swallowed smaller too-big-to-fail banks that were failing during the height of the crisis, preventing a financial calamity from becoming a financial apocalypse. Government officials begged them to assume the obligations of their dying competitors to help stabilize the system during a panic, and they agreed, sometimes with government help, sometimes without it. If JP Morgan hadn’t been big and strong enough to absorb the hemorrhaging balance sheets of Bear Stearns and Washington Mutual, we might well have endured a depression.
- A larger problem may have been money market funds.
Let’s review what a bank run looks like:
In 2008, money market funds were largely like banks–if you ever hear the term “shadow banking,” money market funds are one example. They take investors’ money and invest in short-term debt. Here’s a sampling of them (with some savings accounts):
As Wikipedia kindly explains:
a money fund is a “virtual bank”: the assets of money funds, while short term, nonetheless typically have maturities of several months, while investors can request redemption at any time, without waiting for obligations to come due. Thus if there is a sudden demand for redemptions, the assets may be liquidated in a fire sale, depressing their sale price.
The SEC, which oversees money funds, issued final rules to address this problem in 2014. One such rule is holding a certain proportion of liquid assets in their portfolios, for example, U.S. government debt with a short maturity (Treasury bills), which are readily saleable in the market in case the fund is in trouble.
- Saying “Glass-Steagall” doesn’t mean you know what you’re talking about.
The Glass-Steagall Act is the 1930s regulation that separates commercial banking (e.g. the side of Wells Fargo that holds your bank deposit) and investment banking (the side of Wells Fargo that trades and underwrites securities). Legislation weakened it in 1999, which many blame for leading to the crisis. The logic goes like this: Large banks were able to use the money they got from deposits to finance speculation in toxic securities. If that was an issue, then a restriction in the spirit of Glass-Steagall, the “Volcker rule,” which limits banks’ speculation, ought to make a difference. But…
In fact, some of the financial institutions that fared the worst, such as Bear Stearns, AIG, Lehman Brothers and Washington Mutual, weren’t part of large bank holding companies at all.
“I have often posed the following question to critics who claim that repealing Glass-Steagall was a major cause of the financial crisis: What bad practices would have been prevented if Glass-Steagall was still on the books?” wrote former Federal Reserve Vice Chairman Alan Blinder. “I’ve yet to hear a good answer.”
- We act like Dodd-Frank and other new regulations have done nothing.
The Dodd-Frank Act of 2010 is controversial. It has 16 title provisions and spans 2,000+ pages, so I’m not going to try to summarize it here. Suffice it to say it has a lot of provisions and thus a lot of consequences. Some say it did too little, and others say it went too far (which I might take as a sign of good compromise), but no one would argue with the fact that it’s done something.
One thing Dodd-Frank does is allow for the Fed to incur on large banks a capital surcharge, or an additional requirement for capital based on the bank’s size and systemic importance.
Notably, the postfinancial-crisis regulatory regime reflects this. It has been crafted to take more than size into account. So while Wells Fargo is bigger, it has a lower capital surcharge than Citi because it is less interconnected, less complex and has a far smaller derivatives book. (WSJ)
So does the new regulatory regime encourage banks to downsize? Yes and no. J.P. Morgan, for example, was warned it would be slapped with a 4.5 percent capital surcharge–that is, the capital surcharge increases the amount of capital it would be required to hold, increasing resiliency in time of crisis but reducing its ability to make profits. It quickly reduced its overall assets by 10% (i.e, got smaller), ending up with a 3.5 percent surcharge instead. But not every megabank may make the same choice.
That said, that’s hardly the only angle regulators are taking on the big banks these days. Just this past week the Fed and the FDIC, which both oversee the largest banks, said the “living wills” of these banks are not credible enough if a crisis requires them to wind down. “It signals that [regulators] are serious,” said former congressman Barney Frank. The takeaway here is that big banks are already under pressure to reduce their systemic footprint.
There is still a lot of work to be done. For example, the government still hasn’t addressed GSE (Fannie Mae and Freddie Mac) reform, as these two still have a huge role in the mortgage market and thus pose a risk to the financial system. And we have yet to determine whether all these new regulations strain the financial sector excessively and have a serious impact on the economy. But we haven’t done nothing.
It’s natural for Americans to distrust big banks. In general, we don’t like big banks, big government, big corporations. But we’re a big country, with a big, complex financial system, so we need to think in those terms.
I won’t lie–even to me this stuff is kinda boring. But before we jump up and decide we know what to do with Wall Street, we ought to read up on and think through the problems that it actually has.