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.