When the market crashed in September of 2008, many people believed it was the result of unchecked financial institutions that needed far more government oversight than they were actually getting. As a result of the overwhelming frustration of the American people and the feeling that the government needs to protect its people, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed through Congress in July 2010.
The point of the Dodd-Frank Act was to eliminate “too big to fail”-the motto given to financial institutions capable of bringing down the entire financial system if they were to collapse. Republicans and Democrats rarely agree on anything, but they both subscribe to the idea that in order for the financial system to be secure moving forward, the US government has to eliminate “too big to fail.” But is this really an achievable task? Can government really put an end to this “too big to fail?”
It depends on someone’s view of the financial system. One school of thought is that the 2008 crisis was caused by a lack of good government regulation of financial institutions. The other school of thought is that massive commercial banks with so much of their money invested in so many areas of the economy are an inherent risk to the economy and government regulation cannot fix the problem. Therefore, they need to be broken up.
Through examination of the critical Volcker Rule in the Dodd-Frank Act, we can determine how effective regulation will be and if it is necessary to break up the banks.
The Consequences of the Repeal of Glass-Steagall
If the cause of the financial crisis really was a clear lack of regulation, then the next question is: what areas were not regulated enough? The most common critique originates with the partial repeal of the Glass-Steagall Act (GSA) in 1999 that broke down the traditional firewall between commercial and investment banks. This allowed commercial banks that were strictly in the business of taking deposits to start engaging in traditional investment banking behavior like underwriting securities, a far more risky practice.
What got commercial banks into trouble during the Great Recession was the holding of mortgage-backed securities. Had the GSA still been in place, commercial banks technically still would have been able to have mortgages on their balance sheets. After all, one of the primary functions of a commercial bank is loaning money to people for buying homes.
However, commercial banks, prior to the partial repeal of the GSA, traditionally didn’t securitize these mortgages, tranche them into different classes based on risk premium, and auction them off to other financial institutions. The fact that commercial banks were legally allowed to do this gave rise to a boom in the trading of mortgage-backed securities.
Had Glass-Steagall still been in place, the volume of trading with mortgage-backed securities, one of the primary catalysts of the Great Recession, would have been lower. Then, when the housing bubble burst, financial institutions would have been better protected from the losses because they wouldn’t have been holding so much securitized debt in the form of mortgage-backed securities.
The Volcker Rule
Named after the towering former Chairman of the Federal Reserve, the Volcker Rule is the part of the Dodd-Frank Act that aims to bring back elements of the Glass-Steagall Act by eliminating proprietary trading from commercial banks. Eliminating proprietary trading means banks can no longer use depositors’ funds to trade securities, derivatives, commodities futures, or options because these trading activities do not benefit the banks’ customers.
The Volcker Rule though does not prohibit commercial banks from underwriting, market making, trading of government securities, and acting as brokers, agents, or custodians. So there is no reinstitution of the strict division between commercial and investment banks, but there is a limit to what kind of securities they can trade (i.e. they can no longer trade mortgage-backed securities). All banks have to comply with this rule by July 21, 2015, meaning that they must shed all high-risk assets that don’t comply with the new rules from their balance sheets.
Unfortunately, there are some exceptions. Banks can keep certain assets on their balance sheet if they can prove that they’re using it as a hedging strategy to reduce their risk on another legal investment they have made. Many people fear this will just open a back door for proprietary trading. Hopefully, this isn’t the case, but many are already speculating that the Volcker Rule is also a victory for the banks.
The Alternative: Break Up the Banks
Another way to end “too big to fail” is to quite literally remove the “too big” part by breaking up the banks in this country. There are many who believe that the banks have become simply too large to function efficiently and they in turn pose too large of a threat to society.
For example, the Big 4 banks in the United States (Chase (JPM) , Wells Fargo (WFC) , Bank of America (BAC) , and Citigroup (C) ) hold 40% of all US customer deposits. As of last December, there were 6,891 banks in the United States. That means 0.06% of banks control 40% of the consumer deposits.
And the idea of breaking up the banks is not as radical as it might sound. In 2012, former chairman of Citigroup John Reed told the Financial Times that banks should break up to dilute the risk they pose to the global financial system. Specifically, he said that a bank like Citi could easily cleave into two or three different branches.
There are also those who are skeptical of the United States’ ability to regulate the banks. There are accusations of corruption that are not unfounded and that could be extremely dangerous to the financial system as a whole if they aren’t corrected. For example, a report surfaced in 2010 indicating that the New York Federal Reserve Branch had been helping Lehman Brothers hide their insolvency prior to them going bankrupt. Basically, the New York Federal Reserve accepted junk bonds from Lehman brothers as collateral for short-term loans, a clear violation of their charter that only permits them to accept investment grade assets as collateral.
And big banks also buy big influence in Washington. Last year, the big 4 banks spent nearly $20 million in lobbying efforts in Congress. Obviously, this isn’t illegal behavior, but politicians generally know better than to bite the hand that feeds and they tend to protect those who show their faith through big contributions.
Bring Back Glass-Steagall
One possible course of action would be to reinstitute the Glass-Steagall rule. The fact is that there were no major financial crises between 1933 and 1999, the time when it was in effect. The Volcker Rule is a good start, but the lack of a clear rule forbidding commercial banks from engaging in the behavior of investment banks leaves room for these commercial banks to make risky investments under the umbrella of hedging their bets on an asset they already hold.
The Volcker Rule will help reign in some of the excessive risk undertaken by commercial banks, but it doesn’t go far enough. Reinstating the Glass-Steagall Act would have been the best course of action, but the problem is that it cuts into the profitability of the banking sector and the banks won’t take too kindly to that.
Breaking up the banks is also a good option, but that is completely politically unfeasible. The Big 4 banks would fight to the death to ensure that it doesn’t happen and I don’t think anyone would be on Congress standing up to them. A reinstitution of Glass-Steagall though is more politically feasible. After all, both Republicans and Democrats want to ensure that “too big to fail” is eliminated. Sixty-six years of history tells us that Glass-Steagall is the most effective way to do so.