The weak spot in the financial reform bill

Bank size doesn't matter much in the financial reform bill. But it should. The Senate needs a debate, with Republican support, on whether to trust regulators to decide the size of the biggest banks.

Democrats are right. The Senate needs a full and rigorous debate on financial reform. But any debate must tackle one of the most critical issues not yet resolved from the 2007-09 crisis on Wall Street:

Should big banks be left big?

President Obama says yes. He backs the main Democratic bill in the Senate that would rely largely on regulators to use a new set of enforcement tools to better manage the risks that financial institutions take. He’s less worried about megabanks, even if they are “too big to fail.”

Big banks are not inherently risky to the financial system, say Obama administration officials. Rather, the main issue is whether a bank has gone too far with bad loans, extended credit, or flimsy investments. If so, new tools would allow regulators to dismantle a big bank quickly without a taxpayer bailout. In addition, big banks would be required to keep more backup money on hand as a cushion for a crisis.

Even a smaller bank can bring down Wall Street, as the collapse of Lehman Brothers nearly did in 2007, if their risks are woven widely into other institutions. And besides, the United States needs big banks to be competitive in a world of big banks.

These are all good arguments for the Democratic bill, but such an approach relies heavily on two assumptions:

1. That future regulators will have the wisdom and experience to spot risks in banks before they implode, as investments in subprime mortgages did.

2. That future presidents and lawmakers will not go soft on enforcement because of campaign donations from the largest firms on Wall Street.

If past is prologue, those assumptions could be as risky as the actions taken by Wall Street. And that is why a long debate on financial reform is needed in the Senate – especially if it takes up an amendment offered by a small group of Democrats who want to place a strict cap on the size of financial firms.

Their amendment, known as the Safe Banking Act and sponsored by Sens. Sherrod Brown of Ohio and Ted Kaufman of Delaware, relies on the idea that “too big to fail is too big to exist.” It would cap the size of banks if they have deposits as high as 10 percent of the gross domestic product. It would also limit the size of their nondeposit assets. Any nonbank financial firm would have its liabilities limited to 3 percent of GDP.

This idea of a cap on bank size isn’t new. The 1970 Bank Holding Act gives such power to the Federal Reserve but it has been only loosely enforced. Under pressure from Congress, bank regulators have been reluctant to restrain the growth of banks.

The result? A large concentration of banking power – or half of the nation’s economic output – in just four firms: Bank of America, Wells Fargo, JPMorgan Chase, and Citigroup own half of the mortgages and issue most of the credit cards.

And that concentration is getting worse, according to the Federal Reserve Bank of Dallas President Richard W. Fisher. In the past two decades, he said in a recent speech, the share of industry assets for the 10 largest banks climbed from nearly 25 percent in 1990 to about 60 percent in 2009.

Mr. Fisher backs a cap on bank size, and last year, former Fed chairman Alan Greenspan hinted at his support when he said: “If they’re too big to fail, they’re too big.” Mr. Greenspan also pointed to the 1911 breakup of Standard Oil by the trust-busting President Teddy Roosevelt. The resulting parts, he noted, proved more valuable than the bigger firm.

Indeed, the question of bank size is as old as the Republic. The issue divided Alexander Hamilton and Thomas Jefferson, and helped lead to the formation of political parties. It also led to the rise of political populism under Andrew Jackson, and in a strange way, unites parts of today’s left and the “tea party” right.

Under the Obama-backed bill, big banks would get special treatment: If a bank begins to falter and seems headed for bankruptcy court, regulators would step in and supposedly dissolve it in order to prevent a larger impact on the financial system. But doubts persist about whether government would actually do that. This leaves the impression that this measure could probably end up saving big banks.

If that impression persists, then today’s big banks could become even bigger. Why? Because creditors would believe big banks are safe from failure. What’s more, smaller banks would try to become big.

Treasury Secretary Timothy Geithner says he will work to limit the size of banks. But as Dallas Fed chief Fisher says, “It takes an enormous amount of political courage to say we are going to limit size and limit leverage.” A law mandating limits would buck up regulators.

Fisher also doubts if big banks are even needed, pointing to the financial problems in Japan, which has had some of the world’s largest banks. Also, a report by the executive director of the Bank of England finds that banks don’t enjoy economies of scale after they reach $100 billion in assets. (The biggest US banks have $2 trillion in assets. And three banks – JPMorgan, Wells Fargo, and Bank of America – each already exceed the proposed cap of 10 percent of GDP.)

So far, this debate over bank size has been largely waged behind closed doors in Congress and the White House. But if the Brown-Kaufman amendment can be put on the floor of the Senate for a vote, then the people will see whether their lawmakers do really trust fallible regulators to get this right – or whether a cap must be enshrined in law.

It won’t be easy to find the right size for banks to make sure one bank failure won’t bring Wall Street down. Congress needs to provide a firmer guide to regulators than the main Democratic bill does now.

You've read  of  free articles. Subscribe to continue.
QR Code to The weak spot in the financial reform bill
Read this article in
https://www.csmonitor.com/Commentary/the-monitors-view/2010/0427/The-weak-spot-in-the-financial-reform-bill
QR Code to Subscription page
Start your subscription today
https://www.csmonitor.com/subscribe