When you talk with Conservatives about regulation, they will generally tell you that government regulation is too pervasive and ineffective; additional regulation is out of the question, and existing regulation should be simplified. Those same conservatives often blame the financial crisis and the Great Recession on government involvement, and claim that if only the markets were free of government interference, rational actors would allow the markets to regulate themselves. However, deregulation during the last three decades eliminated most of the protections put in place after the Great Depression, and put us in a hole we have yet to dig ourselves out of.
Simon Johnson and James Kwak, creator of The Baseline Scenario blog and authors of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, examine the long history of financial regulation and deregulation in their recent book. They show that, without question, the Wall Street banks continue to hold inordinate power over our government and the U.S. economy. They carefully trace the bipartisan financial deregulation that began under Ronald Reagan but continued through each successive administration, leading to the near collapse of the Global economy:
“Never before has so much taxpayer money been dedicated to save an industry from the consequences of its own mistakes. In the ultimate irony, it went to an industry that had insisted for decades that it had no use for government and would be better off regulating itself – and it was overseen by a group of policymakers who agreed that government should play little role in the financial sector.”
For example, Johnson and Kwak explain the SEC agreement of April 28, 2004 that allowed the five large investment banks (Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Sterns) to calculate their own net capital based on internal models, rather than using standard models, allowing them to expand their leverage extensively for the next three years. In fact, the regulation put in place by FDR after the Great Depression was systemically dismantled, and 13 Bankers shows how that dismantlement created massive financial institutions that were not only Too Big to Fail, but too powerful to control:
“The fact that their failure could entail the loss of millions of jobs gave the banks the power to dictate the terms of their rescue. If the government insisted on paying market prices for the toxic assets, or insisted on taking majority control, the banks could simply refuse to go along, secure in the knowledge that the government would have to come back to the table.”
13 Bankers examines many common assumptions about the financial crisis; for example, conservatives tend to blame the entire crisis on Fannie Mae, Freddie Mac, and the Democratic Party. However, Johnson and Kwak artfully disarm that claim:
“The riskiest mortgages, however – the ones that pushed the housing bubble to dizzying heights – were simply off-limits to Fannie and Freddie. The [Government Sponsored Enterprses] could not buy many subprime mortgages (or securitize them) because they did not meet the conforming mortgage standards… ultimately regulatory constraints prevented them from plunging too far into subprime lending. As housing expert Doris Dungey wrote, ‘the immovable objects of the conforming loan limits and the charter limitation of taking only loans with a maximum [loan-to-value] ratio of 80%… plus all their other regulatory strictures, managed fairly well against the irresistible force of innovation.’”
In short, the banks lobbied for years to remove the regulations that limited their size and scope; they developed complex financial instruments that were impossible to understand without a PhD from M.I.T.; they used those instruments to hide risk inside AAA rated securities that ultimately plummeted in value, and to move debt off their books; and finally, they had the nerve to complain about government interference after taxpayers backed up those risky bets.
Last summer, the Financial Reform Law was finally passed by Congress and signed by the President. On The Baseline Scenario, Simon Johnson quickly identified the missing ingredient in the new regulation: it does nothing to reduce the size of institutions that are Too Big To Fail. In 13 Bankers, Johnson and Kwak examine some common arguments about large banks, that they supposedly gain economies of scale, and that our large corporations require large, multi-national banks. In fact, those claims “suffer from a shortage of empirical evidence.” Johnson and Kwak provide good evidence to the contrary; for example, Johnson & Johnson used 11 different banks in their 2008 debt offering, and 13 different banks in their 2007 debt offering.
13 Bankers clearly identifies the systemic risk that TBTF banks offer, and warns of an even more dangerous crisis to come in the next financial cycle. One of the main reasons is that TBTF institutions are effectively subsidized by the government, getting money for lower interest rates than smaller competitors; this occurs because investors know the government will always bail out TBTF institutions; this competitive advantage will provide the TBTF institutions a strong incentive to take excess risk. Ultimately, until TBTF institutions are reduced in size, they will remain dangerous to long-term economic health. Johnson and Kwak propose that commercial banks be limited to 4% of GDP and investment banks to 2% of GDP. This would affect only six institutions: Bank of America (currently at 16% of GDP, JP Morgan Chase (14% GDP), Citigroup (13% GDP), Wells Fargo (9% GDP), Goldman Sachs (6% GDP), and Morgan Stanley (5% GDP). The goal would be to allow these banks to fail without taking down the entire economy with them.
13 Bankers will give you a good understanding of how bankers and the government have navigated the regulatory question over America’s history, and what caused the financial crisis. The book also provides an excellent prescription for tackling the TBTF problem. The Baseline Scenario is also an excellent resource, updated daily.