Judging from the public conversation we’re having as we head into the early stages of the 2020 presidential election, bankers no longer appear to be public enemy number one. Big tech appears to have that title. Still, let’s not forget that the actions of several large financial institutions in the run-up to 2008 were largely responsible for catastrophic job losses of millions of households, the repossession of their houses, the destruction of their retirement savings, the collapse of a multitude of businesses, an ongoing stranglehold into myriad forms of debt, and a relentless lobbying machine that exonerates it from any kind of oversight with real teeth.
The legislative response to this fiasco, the Dodd-Frank Act, is being undermined every which way, and wasn’t all that strong to start with. It was passed in order “to ‘promote financial stability,’ ‘lift our economy,’ and ‘end too big to fail,’” argued financial observer Tyler O’Neil, “and the bill has achieved none of those goals.” In fact, it created a host of perverse incentives that have likely made our problems a whole lot worse. Financial reform might be yesterday’s news, but we are inching closer to another economic crisis, in which the “old news” might very well become new and relevant again.
Why is that? For one thing, Dodd-Frank did not structurally alter the banking system (in contrast to the aftermath of the Great Depression via Glass-Steagall). The big “too big to fail” (TBTF) banks got bigger. And by bigger, we’re talking about a sizable ownership stake over 60 percent of GDP.
One prominent example is the newly established Consumer Financial Protection Bureau (CFPB—an Elizabeth Warren proposal that actually initially proved to be one of the few effective reforms introduced by the new banking legislation). The CFPB has been largely gutted by “acting” head, Mick Mulvaney. Likewise, the oversight provisions for big banks have been watered down by the appropriately named Crapo Bill, and Dodd-Frank’s detailed rule-making injunctions have largely been left to the discretion of bank-friendly executive agencies, such as the Federal Reserve, Office of the Comptroller of the Currency (OCC), and Securities and Exchange Commission (SEC), all of which have historically shown themselves to be prone to regulatory capture.
Even one of Dodd’s contributing architects, Lawrence Summers, in a piece co-authored with Harvard Ph.D. candidate Natasha Sarin, found no evidence “that markets... regard banks as substantially safer today than they were in the pre-crisis period.” Many of the same practices that led to the collapse of the financial system in 2008 are as prevalent today as they were in 2007. These include the revival of some of the most toxic products that contributed to the last crash, such as the synthetic collateralized debt obligation (CDO) and the related collateralized loan obligation (CLO), along with an ongoing regulatory culture that still expresses itself in policy preferences that favor industry interests over those of ordinary citizens.
Given the Democrats’ renewed enthusiasm for antitrust (at least as it applies to big tech), the question is whether “break ’em up” to foster greater competition is the way to go with banks, or whether a more “function-centric” approach to regulation makes more sense going forward. On big tech, I’ve written before that size per se may not be the best benchmark to establish optimal regulation. The same might be true for banks.
Simply mandating a breakup in the sector, married to “free market” competition and other market-based reforms, is unlikely to do the trick (that criticism applies as much to GOPers as it does to Democrats). As professors Marc Lavoie and Mario Seccareccia have observed, “greater competition could be a good thing in industries producing, say, ‘widgets,’ since the lower the price that could potentially ensue as a result of lower profits and greater productivity that would be impacted by the competition would have positive welfare benefits for the community at large.” But Lavoie and Seccareccia also recognize that banking is not only about profit for profit’s sake or competitive free markets; therefore, “applying these principles of competition to the banking sector, where there exists tremendous externalities, could be disastrous.”
One of those “externalities” arises from the fact that the banking sector has a unique social dimension that in many respects does not readily lend itself to all of the dictates of a competitive free market system. There is a reason why our government made a conscious policy decision after the Great Depression to guarantee the liabilities of the banking system via the Federal Deposit Insurance Corporation (FDIC). It was to protect the integrity of the payments system, the lifeblood of an economy, as well as the businesses and consumers who relied on the provision of credit provided by the banks.
A controlled oligopoly that disincentivizes banks from embracing risky speculation is one way to go (it works reasonably well in Canada, for example) because it focuses the regulatory thrust on function and outcome, rather than size alone. However, the U.S. banks are much bigger in asset size. “Too big to fail” (TBTF) is relevant here because Dodd-Frank has done nothing to stop the banks from getting bigger, even though they pursue many of the same reckless policies that caused their banks to blow up in the last cycle. In fact, the implicit TBTF safety net has virtually guaranteed that bankers would continue to take on excessive “tail risk” (i.e., too high a risk of ruin), argues Professor Edward Kane.
It is in that sense that size matters: much as the costs of a massive environmental cleanup increase in proportion to size, so too are the social and economic externalities much higher when associated with a big bank. But at the core, it is function married to TBTF that creates the root problem; simply using antitrust to foster competition is unhelpful if all such competition does is to drive banks, regardless of size, to embrace increasingly reckless activities that augment their respective bottom lines, and do so in a way that ultimately compromises the integrity of the payments system. There are some things banks should not be allowed to do, period.
So what’s the right approach: do high levels of concentration in the banking sector promote greater financial instability, or is it a question of function? In truth, they are interrelated, but function matters more.
Ask any neutral observer today whether Goldman Sachs or the Japan Post Bank (the world’s biggest deposit holder) poses a greater threat to financial stability and virtually all will agree that it is the former. That is because systemic risk is largely engendered via function, and “interconnectedness,” rather than asset size. In contrast to Goldman Sachs (or virtually any large American commercial or investment bank), the range of activities of the Japan Post Bank is limited to a fairly mundane roster of traditional banking functions—it is primarily a savings institution. As its Wikipedia page notes, “its only loan products are overdraft lines secured by time deposits and Japanese government bonds on deposit with the bank.” This makes it highly stable, despite its massive size.
Nobody is realistically suggesting that we restrict our banks’ functionality to the degree of the Japan Post Bank. We can’t turn back the clock that far. But the Japan Post Bank example is an important illustration that a simplistic focus on size isn’t enough.
The corollary also applies: a group of relatively small institutions that act in a correlated fashion can be just as dangerous to the payments system as one large entity if the underlying activity in which they engage collectively is unsafe. Lehman Brothers’ activities were being replicated elsewhere (the “interconnectedness” problem), by others. Had it just been one small bank, the problem could have been better contained. Again, function supersedes size in terms of regulatory priority.
By the same token, it’s too pat a conclusion to argue that the collapse of a small institution such as Lehman Brothers somehow absolves the big banks. The root cause of Lehman’s failure was that it was a relatively small institution struggling to compete with the TBTF banks, whose massive balance sheets gave them a built-in advantage over the smaller competitor. Working to match the returns of the bigger banks, Lehman’s smaller balance sheet forced management to undertake further riskier activities (as well deploying dangerous levels of leverage). The resultant toxicity of their balance sheet made Lehman unsalvageable, leading the government to let it go bust.
“Let it go bust” is harder to do with a bigger bank. The externalities can be catastrophic. At the same time, the public instinctively understands the benefits of the implicit TBTF backstop accorded to big banks and hence continues to “vote” with its deposits. Which is to say that banking customers have increasingly migrated to these very same behemoth institutions precisely because the government has repeatedly shown that it will not let them go under (in contrast to smaller institutions like Lehman). America’s three largest banks by assets—JPMorgan Chase, Bank of America, and Wells Fargo—“have added more than $2.4 trillion in domestic deposits over the past 10 years, a 180% increase,” according to an analysis of the regulatory data conducted by the Wall Street Journal in 2018. (In the case of Wells Fargo, this ongoing deposit growth is truly incredible, given that the bank has seen its already low reputation decline further, in light of the scandals that have recently been uncovered.)
The same WSJ report goes on to note that this deposit growth represents “an increase from 20% of the country’s total deposit base in 2007 to 32%, an amount [that] exceeds what the top eight banks had in such deposits combined in 2007.” Add Citi to this group, and you have four banks holding almost half of America’s total deposit base.
The WSJ article also points out that “45% of new checking accounts were opened at the three national banks, even though those lenders had only 24% of U.S. branches… [whereas] regional and community banks… had 76% of branches but got only 48% of new accounts.” That matters because “new checking customers, who tend to be younger, are valuable to banks because they often provide more business later on by, for instance, taking out a mortgage or opening a brokerage account.”
Rapid, unchecked business expansion, combined with regulatory laxity and TBTF bailouts, has therefore given banks an enormous incentive to get as big as possible. Dodd-Frank hasn’t changed that. In fact, a working paper commissioned by the Federal Reserve Bank of Philadelphia by authors Elijah Brewer III and Julapa Jagtiani has furnished multiple examples of banks paying significant premiums to ensure that they would be over the asset sizes commonly viewed as the requisite thresholds to become too big to fail.
But TBTF is even worse than that, because in many cases, it can actually sustain the lifespan of an otherwise insolvent bank, what Professor Ed Kane calls “zombie” banks: “Insolvent Living-Dead firms whose creditors would force them into bankruptcy were it not for various governments’ implicit TBTF guarantees” (Deutsche Bank is one example that immediately springs to mind). That matters because if you’re a bank CEO and you know that in reality your bank is already insolvent, what’s the disincentive from continuing to speculate with the bank’s balance sheet? TBTF enhances reckless moral hazard.
Although banks consistently lobby the government when an attack is made on their “profit-making activities,” the focus of those lobbying efforts obviously shifts to bailouts, the minute they are about to blow up. All of a sudden “government-led socialism” doesn’t seem so pernicious. It is not unreasonable to restrict the banks’ activities, especially when deposit-taking institutions are in a position unique to virtually any other business. The government underwrites their main liabilities—i.e., their deposit base—via the FDIC. No other business is afforded this level of protection.
Likewise, regulation has become increasingly complex and cumbersome in direct proportion to the complexity of the activities undertaken by the banks themselves. That’s often used as an excuse to minimize regulation, when in fact it should provoke a different response: namely, restricting the range of systemically dangerous activities/financial innovations, so that the regulation accordingly can be simplified, and easier to enforce. (Parenthetically, a function-centric approach is better here than simply focusing on boosting capital buffers, which many bank reformers have advocated. To be sure, capital buffers do constitute an important insurance policy for a bank in the event of a financial calamity, but regulation optimally should tackle the activities that give rise to the need for the “insurance policy” in the first place.)
If banks persist in undertaking a proscribed activity via regulatory arbitrage, or some other form of legerdemain, the challenge for policy makers/regulators is to contain the resultant fallout so that it does not endanger the financial system as a whole (as well as jailing the offending bankers so that “too big to fail” doesn’t morph into “too big to jail,” as clearly occurred in the 2008 crisis aftermath). At a bare minimum, the goal should be, as Keynes argued in Chapter 12 of the General Theory, for finance to act as a handmaiden of industry (or productive “enterprise”) rather than the other way around, since the latter condition results in an overly financialized system that is dominated by largely unfettered rentier speculative activity.
Unfortunately, Keynes’ aspirations remain unfulfilled. Banks dominate industry and work in ways that derogate from broader public purpose. The tolerance of TBTF doctrine illustrates that we don’t yet have the political will to curb the speculative activities of the large deposit-taking institutions (again, another byproduct of their size, as it gives the banks more lobbying muscle to resist such changes). But if we don’t come to grips with this problem, there will inevitably be another crisis. In fact, it’s almost certainly too late to avoid that eventuality. But at a minimum, let’s hope we do better when the next banking crisis hits, as it surely will, much as night follows day.