Guest Contribution: “Who is right on US financial reform? Sanders, Clinton, or the Republicans?”

Today we are pleased to present a guest contribution written by Jeffrey Frankel, Harpel Professor of Capital Formation and Growth at Harvard University, and former Member of the Council of Economic Advisers, 1997-99. This post is an extended version of a column that appeared in Project Syndicate.

Eight years after the financial crisis broke out in the United States, there is as much confusion as ever regarding what reforms are appropriate in order to minimize the recurrence of such crises in the future.

There continue to be some good Hollywood movies concerning the crisis, including one nominated for multiple Oscars at the February 28 Academy Awards. The Big Short has been justly praised for making such concepts as derivatives easy for anyone to understand. As has been true since the first of the movies about the crisis, they are good at reflecting and crystalizing the audience’s anger. But they are not as good at giving clues to those walking out of the theater as to the implications. What policy changes would help? Who are the politicians that support the desirable reforms? Who opposes them?

If an American citizen is “mad as hell” at banks, should he or she respond by voting for the far left? By voting for the far right? (Or by refusing to vote at all?) Each of these paths has been chosen by many voters. But each is misguided.

There is a place in political campaigns for short slogans that fit on cars’ bumper stickers. (“Wall Street regulates Congress.”) And there is a place for ambitious goals. (“Shrink the financial sector.”) But the danger is that those who are attracted to inspirational rallying cries and sweeping proposals will lack the patience required to identify which is the right side to support in the numerous smaller battles over financial regulation that take place every year and that ultimately determine whether our financial system is becoming structurally safer or weaker.

Breaking up banks

Senator Bernie Sanders has proposed breaking up the banks into little pieces. It is the centerpiece of his campaign for the Democratic presidential nomination. The goal is to make sure that no bank is too big to fail without endangering the rest of the financial system. That would require quite a sledge hammer. The American banking system historically featured thousands of small banks. But having thousands of small banks did not prevent runs on depositary institutions in the United States 1930s.

Continental Illinois was the original case of a bank that was deemed “too big to fail” in 1984, when it was bailed out by the Reagan Administration. So banks would have to be broken into smaller pieces than that. Merely turning the deregulatory clock back 30 years would not be enough to do it.

I am not sure whether or not, if one were designing a system from scratch, it would be useful to make sure that no bank was above a particular cap in size chosen so that any of them could later be allowed to fail with no further government involvement. I do know that having a financial system dominated by just five large banks did not prevent Canada from sailing through the Global Financial Crisis of 2008-09 in better shape than almost any other country.

Attacking banks is emotionally satisfying, for understandable reasons. But it won’t prevent financial crises.

Reforms proposed by Hillary Clinton

Hillary Clinton is correct in pointing out that the most worrisome problems lie elsewhere: hedge funds, investment banks, and the other so-called non-banks or shadow banks. These are financial institutions that are not commercial banks and that therefore have not been subject to the same regulatory oversight and the same restrictions on capital standards, leverage, and so on. Recall that Lehman Brothers was not a commercial bank and AIG was an insurance company.

Secretary Clinton has done her homework and proposes specific measures to address specific problems with the non-banks. Four examples:

  • She puts priority on closing the “carried interest” loophole that currently allows hedge fund managers to pay lower tax rates on their incomes than the rest of us pay. This is a more practical step than most proposals to address the very high compensation levels in the financial sector that cause so much resentment. It would help moderate inequality, reduce distortion, and raise some tax revenue to help reduce the budget deficit.

  • She proposes a small tax targeting certain high-frequency trading prone to abuse. (Sanders proposes a tax on all financial transactions.)

  • She also supports higher capital requirements on financial institutions, including non-banks, if necessary, beyond those increases already enacted.

  • She proposes a “risk fee” on big financial institutions that would rise as they get bigger. This is reminiscent of a fee on the largest banks that the Obama Administration proposed in 2010, to discourage risky activity while at the same time helping recoup some revenue from bailouts. It was going to be part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, but in the end three Republican senators demanded that it be dropped as their price for supporting it.

The Dodd-Frank reforms

The Dodd-Frank law was a big step in the direction of needed financial reform. It included such desirable features as increasing transparency for derivatives, requiring financial institutions to hold more capital, imposing further regulation on those designated “systemically important,” and adopting Elizabeth Warren’s idea of establishing the CFPB, the Consumer Financial Protection Bureau.

It goes without saying that Dodd-Frank did not do everything we need to do. But the law would have moved us a lot further in the right direction if many in Congress had not spent the last six years chipping away at it. Those who worked to undermine the financial regulatory reform legislation – mostly Republicans – appear to have paid no political price for it, since most of these issues are below the radar for most voters. [I have given my subjective evaluation of various specific legislative proposals, some passed and some not, on a 1-page slide.]

Here are a few examples of how Dodd-Frank has been undermined, in addition to the abandonment of the fee to discourage risk-taking by large banks or an earlier proposed global bank levy.

  • Auto-dealers, amazingly, lobbied successfully to get themselves exempted from regulation by the CFPB, allowing the resumption of some abusive lending practices that resemble the sub-prime mortgages which played such a big role in the 2008 financial crisis.

  • The Dodd-Frank law was supposed to require banks and other mortgage originators to retain at least 5% of the housing loans they made, rather than repackaging every last mortgage and reselling it to others. The reason is that the originators need to have “skin in the game” in order to have an incentive to take care that the borrowers would reasonably be able to repay the loans. Under heavy pressure from Congress, that requirement was gutted in 2014.

    This one is not especially the fault of the Republicans. Virtually every American politician in both parties still acts as though the goal should be to get as many people into as much housing debt as possible, even if many will not be able to repay the loans and even after such practices caused the worst financial crisis and recession since the 1930s. Other countries manage to do this better.

  • The Congress has refused to give regulatory authorities such as the SEC (Securities and Exchange Commission) and CFTC (Commodities Futures Trading Commission) budgets commensurate with their expanded regulatory responsibilities, in a deliberate effort to hamper enforcement. Many Republicans appear still to believe that these agencies represent excessively aggressive regulation. This is remarkable in light of the financial crisis. Remember that Bernie Madoff — who is himself now the subject of new Hollywood portrayals — was able to run his Ponzi scheme right up until 2008 despite repeated tip-offs to the SEC, because it systematically refrained from pursuing investment management cases during this period.

Who can get the job done?

Sanders has indicated that if he were president, nobody with past experience on Wall Street would be allowed to serve in his administration. A blanket rule like this would be a mistake. Judging people by such superficial criteria as whether they have ever worked for Goldman Sachs, for example, would have deprived us of the services of Gary Gensler. As CFTC chairman from 2009-2014 Gensler worked tirelessly to implement Dodd-Frank. To the consternation of many former Wall Street colleagues, he aggressively pursued regulation of derivatives and, for example, prosecution of a case against five financial institutions who had colluded to manipulate the LIBOR interest rate (London Interbank Offered Rate]. Yet Sanders tried to block his appointment in 2009.

Financial issues are complicated. Getting the details of regulation right is hard. (The examples mentioned here are just the tip of the iceberg.) We need leaders and officials who have the wisdom, experience, patience, and perseverance to figure out the right measures, push for their enactment and then implement them. If such people are not the ones who receive political support for their efforts, we should not be surprised if the financial sector again escapes effective regulation and crises recur in the future.

This post written by Jeffrey Frankel.

21 thoughts on “Guest Contribution: “Who is right on US financial reform? Sanders, Clinton, or the Republicans?”

  1. PeakTrader

    So, “Clinton has done her homework” – more regulations, taxes, and fees on top of more regulations, taxes, and fees.

    Politicians can go too far micromanaging the economy to the point of stagnation.

    Too many regulations, taxes, and fees can cheat borrowers and investors just as much as too few regulations, taxes, and fees.

    Are we willing to pay the insurance for a risk free society?

    Also, I may add, it’s harder for Canadians to buy houses than Americans – they have to wait longer and live in smaller houses.

    1. Mike V

      1. Do you have any evidence of your last statement, and 2. why are smaller houses and longer wait times necessarily bad? Part of the reason of the housing collapse was over saturation with mansions that had no buyers and overly eager lenders getting people into houses before they were financially ready for them.

      Funny enough, Texas has among the most regulated banking/housing markets in the US and they weathered the storm better than most states.

      1. PeakTrader

        Sure, you can make it safer for lenders with more regulations. So, you can buy a smaller house when you’re older.

        Based on Census data: “The median-size U.S. house has increased in size from 1,525 square feet in 1973 to 2,491 in 2013.”

        According to the Canadian Home Builders Association in 2012: “Canada-wide, new home builders responding to the latest Pulse Survey report the average size of a new single-detached house built in their market at about 1,900 square feet.”

      2. spencer

        I’ve long believed that Canadian house are smaller because they can not deduct the taxes on their mortgage.

        Do you have evidence to the contrary.

        1. PeakTrader

          That may be true. And, Canadian houses may be more expensive. Canada weathered the financial crisis in better shape. Perhaps, because regulations, taxes, and fees benefitted lenders at the expense of borrowers. For example:

          Canadian article 2015:

          “If you have a down payment of less than 20 per cent, you have to pay a hefty premium to insure your lender in case you default on your payments. The amount is usually added to your mortgage principal, which means it’s out of sight and out of mind. But it still costs you.

          With a down payment of less than 10 per cent (5 per cent is the minimum), the cost of mortgage insurance rose in June to 3.6 per cent of the purchase price from 3.15 per cent. Larger down payments short of 20 per cent were unaffected and range from 2.4 per cent down to 1.8 per cent. You’ll pay provincial sales tax on those amounts in Manitoba, Ontario and Quebec. More importantly, you’ll incur extra interest charges by adding these amounts to your mortgage balance.”

          1. PeakTrader

            You say: “PMI rules are the same in the US.”

            Your own link says: “Mortgage lenders make many borrowers who don’t have 20% to put down on a home purchase private mortgage insurance (PMI) to protect the lender if the borrower is unable to pay the mortgage.”

            And: “…typically the premiums for private mortgage insurance can range from $30-70 per month for every $100,000 borrowed.”

          2. PeakTrader

            Anyway, Canadian banks get their money:

            “Canadian mortgages carry a fixed interest rate for a maximum of five years, and rates are then re-negotiated for the next five years, similar to a five-year adjustable rate. This helps in allowing banks to reach a better maturity between the relevant assets (i.e. loans, mortgages) and interest income on their books, and their liabilities (deposits) and interest expense, which protects them.

            Roughly half of Canadian mortgages currently retain mortgage insurance vs 30% in the U.S..

            Mortgage insurance in Canada also covers the full loan amount for the full life of the mortgage. It cannot be eliminated like it can in the U.S. when the property value exceeds the mortgage balance. The higher percentage of mortgage insurance payers in Canada is thought to help stabilize Canada’s mortgage and housing markets

            Private insurance companies in Canada can insure mortgages and they have the authority to approve or reject the property appraisal. This helps to give them a strong financial incentives to only approve realistic property appraisals.

            Almost all Canadian mortgages are full recourse loans, meaning that the borrower (homeowner) is fully responsible for the mortgage even in the case of foreclosure. If a bank in Canada forecloses on a home with negative equity, it can file a deficiency judgment against the borrower, which allows it to attach the borrower’s other assets and even take legal action to garnish the borrower’s future wages.

            Prepaying mortgages in Canada is allowed however there is much stiffer prepayment penalties (i.e. such as paying three months of mortgage interest) than in the U.S. This policy in the Canadian real estate system has discouraged the kind of refinancing that took place in the United States.

            All Canadians pay the same premium based on the size of their down payment. That means even good-risk clients are charged the same as poor-risk clients.

            In Canada, the entire mortgage premium is due upfront and is usually rolled into the principal of the mortgage. This means homeowners must pay the interest on their premiums.

            In the U.S. most homebuyers pay their premium monthly. Thus, on average, a homeowner can expect to pay between $50 – $100 per month for mortgage insurance, courtesy of the Mortgage Insurance Companies of America (MICA) trade association. The savings on interest alone due to the monthly schedule can be significant.

            Canadians are forced to purchase more coverage than one would expect they would need. First of all, mandatory insurance in Canada applies for anyone that puts down less than 25% of their down payment on a home. And second, Canadian homebuyers must purchase 100% coverage for their mortgage.

            When one pulls together all these differences, it means that Canadians have greater costs and less flexibility in their mortgages.”

  2. Marko

    Hillary Clinton as “Lucy” :

    ” C’mon , Charlie Brown , kick it – I won’t pull it away this time , I promise ! ”

    I could be wrong , but I think the Charlie Browns of the voting public are starting to catch on. The gushers of money that always flow from Wall Street to Clinton may have provided a clue :

    Top Industries, federal election data – Hillary Clinton
    #1 Securities & Investment $18,754,115

    vs. Sanders :

  3. A

    Regulators seem to struggle with conflicting interests. During calm periods, large financial institutions seem to chip away at regulatory authority. But in panics, regulators take advantage of concentrated institutional platforms because it allows for rapid coordination. If you need to do something big in one weekend, it’s easier to deal with 10 large banks, than to work with 300 banks of the same asset size, with different accounting, credit recognition procedures, back offices, and software.

  4. Tom Mullaney

    What about funding leverage, i.e. borrowing short to lend long? REPO, REPO, REPO !!!

    What about the rating agencies? Unbeaten and unbowed still !!!

    1. PeakTrader

      What about derivatives?

      What about speculation in general?

      Good news about rating agencies – they downgraded Greece’s securities to junk to worsen their debt crisis.

  5. Pookah Harvey

    Frankel’s logic seems to be that Dodd Frank is heading in the right direction but the large financial institutions are so powerful that “Dodd-Frank has been undermined”.
    Frankel’s answer to this problem is to NOT break these institutions up. No realistic reforms can take place as long as these institutions maintain their power. Money is power, concentrations of money are concentrations of power. These institutions are powerful enough to have captured government as his examples show. How then can any of Clinton’s tweaking the system ever solve the problem. Sanders’ solution goes to the heart of the matter.

    1. PeakTrader

      It’s unnecessary to break-up the large banks, because of “Total Loss Absorbing Capacity. (TLAC)”

      The “Clearing House Association” seeks a balance between “systemic stability, economic growth, and a safe and sound banking system.”

      And, will breaking-up the large financial institutions make that group weaker?

      large financial institutions are needed to function in the global economy.

  6. 2slugbaits

    Prof. Frankel,

    I don’t think there’s much argument that Clinton’s understanding of what’s needed for effective financial reform is a lot deeper than Sen. Sander’ understanding. As politicians go, Clinton is a wonk. No question about it. OTOH, there’s probably nothing wrong with wanting to break-up the too-big-to-fail banks. Breaking up the big banks may not be enough, but it’s not likely to do any harm. About a year or so ago there was an NBER paper (WP#20894) that itemized the major fines and penalties levied against the banks. It came to something like $139B between 2012-2014. Virtually all of those fines were levied against 5 or 6 big banks. It’s a list of the usual suspects. This tells us a lot. It tells us that fines, even very large fines, are viewed as just the cost of doing business. The sheer size and dominance of the TBTF banks allows them to collect rents sufficient to withstand even fines that are larger than the GDP of many countries. And the financial industry is able to capture these rents because of their political leverage, not just their financial leverage. Clinton is right about how to restrict financial leverage. Unfortunately, we have no evidence based on her record as Sen. Clinton then representing New York that she would be willing to tackle the problem of political leverage. Indeed, the concern is that her first priority at 12:01pm on January 20th 2017 will be to plan her re-election, and that will require a lot of cash from the financial sector. One can easily imagine a newly inaugurated President Clinton rationalize putting off financial reform until the 2020 election cycle. In fact, it’s a little difficult to imagine her not rationalizing away tough choices and promising to do those things after 2020. It’s a politician’s equivalent of promising to go on a diet tomorrow as she reaches for that second donut.

    Sen. Sanders has the opposite problem. His heart is in the right place even if his head isn’t. Breaking up the big banks won’t fix the problem. Whereas Clinton needs to distance herself from Wall St. in order to demonstrate her commitment to financial reform, a President Sanders would need to invite Wall St. advice to fill in the substantial gaps in his understanding.

    Clinton’s first concern on January 20th will be her re-election in 2020, which will likely undermine her commitment to financial reform. She knows better in her head, but her heart is in the Oval Office. Sanders’ first concern on January 20th will be to aggressively pull down the financial sector in what could be a reckless and ineffective way. It may also doom his chances for re-election in 2020, which could ultimately undo any good work that he might be able to accomplish…assuming that a GOP Congress will allow him to accomplish anything. So it’s a tough choice for voters. The candidate with the wonkiness and understanding to fix the problem probably doesn’t have a political incentive to follow through with her campaign speeches. And the candidate with the will to fix the problem probably doesn’t have the skill set and political savvy necessary. It’s a Y-u-g-e dilemma. And then there’s the crazy Republican field. Ugh.

  7. FluffytheObeseCat

    In a political economy as sclerotic as ours, there is a great deal to be said for shattering one of the TBTFs, even if it is not an inherently — stand alone — brilliant move. This argument: “Attacking banks is emotionally satisfying, for understandable reasons. But it won’t prevent financial crises.” is beside the point now. Reagan rewrote the rules when he fired the air traffic controllers. He sent the doyens of the establishment into a tizzy when he did it, it was an objectively bad move on many levels………… and he utterly changed the way we did business going forward. Whether that was good or bad is not the issue.

    This: “Attacking banks is emotionally satisfying, for understandable reasons. But it won’t prevent financial crises.” is a patronizing, overly genteel, pettifogging argument in the context of where we are as a nation and an economy. I could hoist my porcelain teacup in defense of it (while giving a high pinkie salute), but that would be foolish in the long run. Business as usual is now taking a long walk on a short pier.

  8. joe

    This reads as something commissioned by the big 5. Full of misdirection. For example, its whole argument against breaking them up is: but it won’t stop a financial crisis, which misses the whole damn point of tbtf and moral hazard and the people being on the hook, and the concentrations of power.

  9. Lyle

    I think there is a way to break the big banks up without doing it by force, just raise the capital requirements to such a level that a bank would be worth more broken up than whole. Then the hedge funds would pile in and force the managements to break up the banks. In one sense this is the story of GE and MetLife. The did not want to be systematically important institutions so they either got most out of the finance business (GE) or broke themselves up. Perhaps raise the capital level to a max where you can only have 2 to 1 leverage, perhaps only on bonds, stocks and the like, and 5 to 1 on regular loans. (Interestingly the leverage ratio for banks in 1914 was about 5 to1, where as it was less than 2 to 1 in 1863). The only folks who loose with the higher equity positions are stockholders and managers.

    1. PeakTrader

      Are you certain only “stockholders and managers” can lose? It’ll shift in different ways than in 1863 or 1914. It will still “force” changes that may be suboptimal to the industry or society.

      1. Lyle

        The idea was basically to raise the capital requirements for the largest banks to the point where they are worth more in pieces than whole. Perhaps done by putting the capital requirements on SIFIs. Actually good for a number of managers who get to be CEOs of the smaller offspring of the big banks.

  10. Steve Adams

    Maybe the title should have been just about Hillary and Sanders – no real analysis of any other approach.

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