Reforming the Banks for Good

(Emmanuel Huybrechts/Flickr)

Despite pronouncements and promises of sweeping reform, many of the conditions that caused the financial crisis of 2008 persist six years after the multi-trillion-dollar bank bailouts began. While several steps have been taken to curb reckless practices, the U.S. financial system is still not safe enough.

Today, the top banks are larger than they were before the crisis and engage in many of the same behaviors that led to the financial meltdown, including using large amounts of short-term borrowing to fund purchases of speculative securities. The largest banks have used their political muscle to shield their enterprises and individual bankers from criminal prosecution and to resist the toughest reforms. While global banks have reportedly paid $100 billion in legal settlements with the U.S. government for crisis-related misbehavior, this may not deter future abuses, because the bad actors rarely have been held personally responsible. Instead, the banks and their shareholders have picked up the check.

The lack of personal accountability will not be lost on bankers riding the next financial bubble. There are many instructive examples. Kerry Killinger, former CEO of Washington Mutual (WaMu), and two other senior executives were sued by the Federal Deposit Insurance Corporation (FDIC) in a complaint alleging they had “widely and indiscriminately” steered borrowers into mortgages they could not afford. While the case was settled in 2011 for more than $64 million, Killinger contributed only $275,000 in cash to the settlement—a slap on the wrist given the roughly $88 million Killinger earned between 2001 and 2007. In 2013 JPMorgan Chase (the bank that bought WaMu) agreed to pay $13 billion to the U.S. government related in part to the sale of bad mortgages to government-sponsored housing enterprises Fannie Mae and Freddie Mac. The settlement was heralded by the government as the largest ever with a single institution in U.S. history. But the board of directors at JPMorgan Chase awarded CEO Jamie Dimon a 74 percent pay increase (to $20 million) that same year. Dennis Kelleher, president of Better Markets, called this move “as shocking as it is indefensible,” noting, “It’s a real slap in the face to the [Department of Justice] and financial regulators who think that the actions that they’ve taken in the last year have been appropriate to punish and deter JPMorgan Chase.” It is hard not to conclude that those who helped create a global financial calamity have not and will not suffer personal consequences.

What a Strong Financial System Should Do

We need a strong, stable, and accountable financial system that serves the real economy. Finance should provide reliable payment systems and channel excess savings into productive commercial and consumer investments. Yet today the largest banks are still engaging in reckless practices that provide short-term benefits but ultimately threaten their solvency. Because they enjoy the comfort of an expanded government safety net (which includes federal deposit insurance and access to loans from the Federal Reserve), these giant firms and their executives can continue to create and benefit from boom-and-bust cycles, privatizing profits in the bountiful years and socializing their losses when they fall.

The lack of personal accountability will not be lost on bankers riding the next financial bubble.

A stronger financial system is possible. We can still follow the approach that worked after the Great Crash of 1929. Beginning in 1933, the Roosevelt administration shut down failed banks, built a wall between traditional banking (deposit taking) and investment banking (securities operations), and regulated securities offerings and markets. This important firewall created under the Glass–Steagall Act was dismantled beginning in the 1980s and completely knocked down in 1999 with the Gramm–Leach–Bliley Act. The Roosevelt administration also worked from the bottom up through the Home Owners Loan Corporation (HOLC), which refinanced one-fifth of all outstanding home mortgages in America. Though some borrowers re-defaulted, 80 percent were able to save their homes. When it dissolved, HOLC returned a surplus to the government.

In contrast to the 1930s, this time around we have not restored financial stability, we have not rescued homeowners, and we have not carried out the necessary reforms to the financial sector. Notwithstanding the sincere efforts of many dedicated legislators and regulators, financial reform has been diluted and delayed by the powerful banks.

The Persistence of Too Big To Fail

The data are indisputable: the top six bank holding companies—JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley—are larger than they were before the 2008 crisis. Together they hold 37 percent more assets than they did five years ago. These six bank holding companies have two-thirds of the total assets in the entire banking system, which includes nearly 7,000 banks.

In early April U.S. banking regulators voted to restrict the largest banks from excessive borrowing or “leverage.” Leverage is the relationship between what a bank owns (assets) and what it owes (liabilities). Banks own a variety of assets including securities, mortgage loans, and commercial loans. Banks also owe a lot; their liabilities include customer deposits and funds borrowed from other financial institutions. The regulators voted for tougher leverage requirements for the top eight banks (which include the six banks identified above as well as State Street and Bank of New York Mellon). Under the rules, the bank holding companies will be capped at borrowing no more than $95 for every $100 in total assets, and their depository institution subsidiaries will be capped at $94. Thus, there would be a minimum 5 percent “leverage ratio” at the bank holding company and 6 percent for its FDIC-insured subsidiaries—double what is required presently. FDIC Chairman Martin Gruenberg noted that “this may be the most significant step we have taken to reduce the systemic risk posed by these large, complex banking organizations.” But these new leverage requirements, which do not go into effect until at least January 1, 2018, fall far short of what is necessary. The new targets lie well below the 20 to 30 percent ratios that economists like Anat Admati and Martin Hellwig recommend in their insightful book The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It.

Even as the regulators began to tighten up, bankers are already gaming the system by using accounting tricks to make themselves look less leveraged. For example, in the fourth quarter of 2013 JPMorgan moved $20 billion in securities to the category of “held to maturity.” Accounting rules allow banks to value any securities that are “held to maturity” (instead of “available for sale”) at their original prices, not their current market values, which fluctuate and can decline. Higher asset values on paper may make the bank look more secure but can mask risks, especially if the bank must later sell the securities at market values that are lower than their original price. The “held to maturity” dodge can be a serious problem even if the securities are indeed held to maturity. If their values do decline (and if they are considered permanently impaired), accounting rules would require the bank to write them down. Whether sold or written down, the bank’s eventual losses could eat away at its equity capital cushion. And according to John Carney of the Wall Street Journal, “the amount of securities banks pledge to hold to maturity rose last year by 61%, to $492.3 billion.”

While most of the largest banks “passed” the Federal Reserve’s annual stress tests designed to ensure they have enough of a cushion to weather a future storm, the tests are not stressful enough. They do not include scenarios such as the funding runs that would simulate the events that Bear Stearns and Lehman Brothers both faced before they collapsed. At the same time that risks are being downplayed, a larger share of bank liabilities are explicitly or implicitly protected by the government. According to the Federal Reserve Bank of Richmond, the amount of liabilities protected by the federal safety net has increased by 27 percent: “The safety net covered $25 trillion in liabilities at the end of 2011, or 57.1 percent of the entire financial sector.”

Bloomberg News calculated last year that the ten largest banks receive $83 billion in annual taxpayer subsidies, with the top five too-big-to-fail (TBTF) banks accounting for $64 billion. In 2014, according to the Telegraph, the Bank of England’s deputy governor for financial stability “admitted [that] he had no confidence a ‘global giant’ could fail safely and described TBTF as ‘perhaps the most important regulatory priority.’” In late March of 2014, the Federal Reserve Bank of New York published a paper that found that the five largest banks have a cost advantage relative to their smaller peers “consistent with the hypothesis that investors believe the largest banks are ‘too big to fail.’” This TBTF advantage means, for example, that these banks borrow by issuing their own bonds at lower interest rates than their smaller competitors.

The Unfulfilled Promise of Bank Reform

With the largest banks far bigger today than they were when they were said to be “too big to fail,” one would expect a stark public assessment of what went wrong with the post-crisis reform of our financial system. After all, the preamble of the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank) explicitly calls for ending “too big to fail.” As then–chairman of the Federal Reserve Ben Bernanke said of TBTF in 2009, “when the elephant falls down, all the grass gets crushed as well.” After this vivid metaphor, Bernanke went on to say: “we really need a new regulatory framework that will make sure that we do not have this problem in the future.”

Yet Treasury officials have been saying that size does not matter. At a congressional hearing in May 2013, Senator Elizabeth Warren asked Treasury Secretary Jack Lew, “How big do the biggest banks have to get before we consider breaking them up? . . . Do they have to double in size? Triple in size? Quadruple in size?” Lew avoided a direct response to the question, suggesting that if TBTF had not ended by the beginning of 2014, more action should be taken. In December 2013 he explained: “I said if we could not with a straight face say we ended ‘too big to fail,’ we would have to look at other options. Based on the totality of reforms we are putting in place, I believe we will meet that test.”

However, newly appointed Fed chair Janet Yellen acknowledged that she is “not positive that we can declare, with confidence, that ‘too big to fail’ has ended until it’s tested in some way.” One test she suggested was to put a failing financial firm through the new “orderly resolution” process created under Dodd–Frank. This would allow the FDIC to borrow from the Treasury (and thus from taxpayers) to finance managing the troubled bank while selling off parts of the bank’s assets. In the likely event that the proceeds from the sale of the failed bank’s subsidiaries and other assets are insufficient, this would leave the taxpayers in the red. The law allows the government to collect money from the surviving banks to pay back the deficit over time. This process was designed as an alternative to the two distasteful choices faced in 2008—either let a TBTF firm file for bankruptcy and allow chaos to ensue (as was the case with Lehman Brothers) or use taxpayer money to bail out any and all TBTF firms. The hope is that the new “orderly resolution” process will allow a single firm to run off the road without another disastrous pileup.

Yet it isn’t clear that this will work in practice. One particular concern is how to manage this process outside the United States, an important consideration given that U.S. banks transact across borders. Another concern is who pays. This “orderly resolution” started out as something the big banks themselves would have to pre-fund. However, due to opposition largely from Senate Republicans, there is no bank-pre-funding mechanism.

Given what is at stake, a “wait and see” approach is ill advised. There are tools in Dodd–Frank, as well as additional proposed legislation, that can make the system safer now.

1. Break up the Banks. Since the crisis there have been several proposals to break up the banks. Among the most notable is the 21st Century Glass–Steagall Act, introduced in 2013 by Senators Elizabeth Warren (D-MA), Angus King (I-ME), John McCain (R-AZ), and Maria Cantwell (D-WA). This bill would reverse the impact of Gramm–Leach–Bliley and once again separate commercial banking (deposit taking) and investment banking (securities operations), as well as place a cap on bank size. It would also address practices that were not around in 1933 when Glass–Steagall was enacted. For example, traditional deposit-taking banks would be banned from hedge fund activities and dealing in swaps (a type of derivative that pays out if a certain event occurs, such as credit default swaps, which allow the swap buyer to bet that some other company will default or go bankrupt). Such a law would have the advantage of avoiding the seemingly neverending efforts to carve out exceptions to new bank regulations.

Support for simplifying banks has come from reformers, regulators, and even industry veterans, including former Citigroup CEO John Reed, who presided over Citi before and after the Glass–Steagall separation between traditional and investment banking was abolished. In a letter to the New York Times in 2009, Reed wrote: “[S]ome kind of separation between institutions that deal primarily in the capital markets and those involved in more traditional deposit-taking and working-capital finance makes sense.”

2. Boost Capital Cushions. Leverage (the use of debt to buy assets) should be reduced throughout the financial system—at bank holding companies, traditional banks, broker-dealers, and less regulated entities such as hedge funds and other private pools of capital. Senators Sherrod Brown (D-OH) and David Vitter (R-LA) have proposed a bill that would require banks with more than $500 billion in assets to have at least 15 percent equity capital, meaning borrowing no more than $85 for every $100 in total assets. Mid-size banks with between $50 billion and $500 billion could borrow a bit more, with a requirement of 8 percent equity relative to total assets.

3. Reduce Bank Dependence on Short-Term Wholesale Financing. Unlike during the Great Depression (before there was deposit insurance), when retail depositors lined up outside banks to pull their money, in the 2008 crisis it was big institutions like money market mutual funds that took their money and ran. Money market funds and other cash-rich investors pulled their cash from Bear Stearns and Lehman Brothers, causing them to collapse. Before it failed, Lehman Brothers relied on $200 billion in overnight loans to finance longer-term assets, including the mortgage-backed securities in its portfolio.

The problem with these uninsured short-term “wholesale” loans (as opposed to more old-fashioned sources of financing, including FDIC-insured deposits) is that if there is a panic, or if confidence in a bank diminishes, the uninsured wholesale lenders run. When they pull their money, the bank will have to sell collateral (usually securities in its portfolio) in order to come up with the cash, or the lender will demand the collateral back. Either way, this type of “fire sale” can result in bank insolvency—and because banks hold similar assets and other banks may be forced to mark their values down or sell at low prices, this can be contagious. The Fed remains concerned about these fire sale risks and is expected to address these risks with new rules. However, there is a legislative fix. As recommended by legal scholars Stephen Lubben and David Skeel, and as proposed by Senator Bill Nelson (D-FL) in 2010, the Bankruptcy Code should be amended to roll back the special treatment given to short-term, wholesale lenders when there is a bankruptcy. If the special protections were removed, these lenders would be much less likely to lend against speculative collateral in the first place.

4. Create a Pre-paid Risk Fund. We need to create disincentives for growing too big to fail. One important step toward this goal is to require TBTF banks to pay an assessment into a fund based on their risk factors such as size, leverage, and reliance on short-term funding. Then, if one of them is put through an “orderly resolution,” this fund could be tapped by the FDIC so that taxpayers would not have to front the expenses. This could also create incentives for banks to better police each other. Requiring banks to pay such an up-front assessment was included when Dodd–Frank was in progress but, under pressure from the banks, was removed before the law was enacted. It is still an idea with support. Former FDIC chair Sheila Bair endorsed the fund in her recent book Bull by the Horns.

5. Impose a Financial Transactions Tax. The growing risk of high-frequency trading, which sometimes involves detecting other investors’ orders so as to trade ahead of them and gain a price advantage, undermines faith in the system. Computerized trading of this type has led to sudden crashes, such as the May 6, 2010 “flash crash,” in which the failure of computer systems resulted in the stock market dropping in value by about 10 percent in just a few minutes. Imposing a financial transactions tax would discourage this disruptive behavior. Several countries already have a financial transactions tax, and as economist Dean Baker has suggested, it may be “the best means” for “reducing the size of the financial sector.”

6. Protect Consumers and Homeowners. Both as a matter of fairness and to discourage false appraisals and predatory loan–based housing bubbles, Congress should amend the Bankruptcy Code to allow homeowners to restructure their underwater mortgages through the bankruptcy courts. We should also enhance the powers of the Consumer Financial Protection Bureau. It was the consumer and housing advocates who saw, well in advance of the regulators, the risk to safety and soundness that predatory and abusive practices presented.

7. Explore Alternatives. We should experiment with alternatives to complement our banking system. One example might be postal banking. The Inspector General of the U.S. Postal Service issued a white paper in early 2014 promoting the concept. Postal banking would involve an expansion of the money-order services that the post office already provides to also include taking deposits, making small loans, and providing bill payment services. Legal scholar Mehrsa Baradaran suggested postal banking several years ago and has recently explored this idea in great detail. Baradaran contends that such a system would help serve the 38 percent of the population that lacks access to mainstream banks and therefore relies on high-cost fringe banking services such as payday lending.

The crash of 2008 has its roots in the deregulation of the early 1980s. Over several decades the systems devised during the New Deal for controlling and policing financial markets were dismantled. New financial innovations were developed without adequate government oversight, and banks were permitted to expand their offerings and grow in size and scope beyond the ability of their own management teams. Implementing reforms like the ones I’ve suggested will be difficult. These proposals challenge entrenched financial interests. But without financial reform, the cycle of speculative excess, bank failures, and public bailouts will only continue. Our country tamed finance once before. We must do it again.


Jennifer Taub is a professor of law at Vermont Law School. Her book Other People’s Houses (Yale University Press) was published in May.