Last week, Senators Sherrod Brown (D-OH) and David Vitter (R-LA) introduced the first bipartisan legislation aimed directly at putting an end to "too big to fail" financial institutions and preventing future bailouts of America's behemoth banks.
Protecting Taxpayers by Strengthening Capital Requirements
Too big to fail banks are so enormous and so intertwined that governments are likely to go to extreme lengths to ensure that they do not fail. These banks enjoy an implicit government guarantee that has been quantified by economists as a hidden taxpayer subsidy that disadvantages smaller banks. Bloomberg recently pegged this subsidy at some $84 billion, a number roughly equivalent to the profits of the nation's largest banks.
The U.S. Treasury likes to call these banks, "systemically important;" a better phrase is "potentially catastrophic." With mergers and buyouts, America's behemoth banks only got bigger during the financial crisis. While the austerity crowd is up in arms about a federal budget deficit projected to be 2.4 percent of GDP in 2015, JPMorgan Chase alone has assets in the range of 25 percent of GDP, under accounting rules that provide a better measure of derivatives contracts. If you add in Bank of America, Citigroup and Wells Fargo -- that gets you to 93 percent of GDP. The failure of any one of these behemoth banks could rock the economy and trigger another massive bailout.
Fury over Wall Street bailouts played a role in unseating many members of Congress in 2010. The bailouts turned out to be far more significant than the $700 billion TARP plan passed by Congress in 2009, which handed out big checks to the big banks -- $25 billion for JPMorgan Chase. In 2011, Bloomberg News revealed that the Federal Reserve engaged in a wholly unprecedented back-door bailout of the financial system with emergency loans amounting to many trillions of dollars. JP Morgan alone took in another $69 billion in these secret loans and the Fed provided massive loans to foreign banks as well.
The Brown-Vitter bill wants the banks to be ready to give themselves a bailout when there is another shock to the financial system. The bill significantly raises the amount of high-quality (equity) capital that the big banks must hold -- foreign banks operating in the United States included. Community banks would stay under the current rules, mid-sized and regional banks would be required to hold eight percent in capital to cover their assets, and megabanks -- institutions with more than $500 billion in assets -- would be required to meet a new 15 percent capital requirement, virtually double their current requirements.
The big banks will scream that the bill is a job-killer, the S&P has already predicted economic armageddon. Don't buy the hype says Allan Meltzer, Professor of Political Economy, Carnegie Mellon University. "Larger equity capital requirements were once the norm. In the banking crisis of 1929-32, no large New York bank failed or required a bailout. Because banks had 15 to 20 percent equity capital reserves."
Limiting the Government Safety Net to Traditional Banking Activities and Creating a More Level Playing Field
The bill cracks down on the Wall Street casino and limits the government safety net (such as FDIC insurance for depositors) to traditional banking activities, not risky derivates trading in the broker-dealer arm of the big banks.
Dennis Kelleher of Better Markets explains: "The bill prohibits the transfer of the liabilities of nonbank subsidiaries onto the balance sheets of insured depositories." Last year, for instance, it appeared that Bank of America was moving trillions in derivatives trades into its FDIC insured bank holding company with the apparent blessing of the Federal Reserve.
The bill also proposes to end Federal Reserve lending to non-depository subsidiaries, through the discount window or emergency lending facilities as they did on a massive scale through the financial crisis. "These two changes would make it clear to capital market lenders that the non-depository subsidiaries of large bank holding companies will not be rescued if they get into trouble," says Kelleher.
These provisions will create a more level playing field for the nation's smaller banks. According to Cam Fine, President, Independent Community Bankers of America the bill "will help end the stranglehold of too-big-to-fail on this nation's financial sector. Doing so will allow for a truly free market economy where all banks are allowed to succeed or fail based on their merits and not the government picking winners and losers."
Support for Downsizing Dangerous Banks to Stabilize the Financial System is Growing
The 2010 Dodd-Frank Wall Street reform law failed to break up the banks or put limits on bank size. It also failed to separate traditional banking activity from the casino.
The Brown-Vitter bill takes an enormous step toward rectifying these problems.
If banks are not able to raise the capital required they could be forced to downsize or deleverage. Senator Brown explained "today the banks are being given a clear choice, either have enough capital to cover our own losses or make yourself smaller."
Support for the concept is growing in some surprising quarters. Numerous bankers have come out in support of shrinking the nation's largest banks including Citi's former chief executive and chairman Sandy Weill and Washington Post columnist George Will thinks it is a cause that should be taken up by conservatives: "By breaking up the biggest banks, conservatives will not be putting asunder what the free market has joined together. Government nurtured these behemoths by weaving an improvident safety net, and by practicing crony capitalism. Dismantling them would be a blow against government that has become too big not to fail."
The authors cite current FDIC Chair Thomas Hoenig, former FDIC Chair Sheila Bair, and Federal Reserve Bank of Dallas President, Richard Fisher as inspiration for their bill, but that is the tip of the iceberg of the prominent players who have recently called for the downsizing or break up of the megabanks. The list includes: former chairman of the Federal Reserve Alan Greenspan, former chairman of the Federal Reserve Paul Volcker, president of the Federal Reserve Bank of St. Louis Thomas Bullard, Deputy Treasury Secretary Neal S. Wolin, head of the Bank of England Mervyn King, the Bank of International Settlements (the "Central Banks' Central Bank"), Nobel prize-winning economist Joseph Stiglitz, Nobel prize-winning economist Ed Prescott, Nobel prize-winning economist Paul Krugman, former Secretary of Labor Robert Reich, former chief economist for the International Monetary Fund Simon Johnson, economist Dean Baker, and many many more. See a more full list here.
In explaining the bill, Senator Vitter commented that in bank matters there has been an "overreliance on having regulators and smart people in the room. What I believe would be more effective is simple systemic change."
We couldn't agree more.
Read the Brown-Vitter bill here.