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Boosting megabanks’ capital cushion could preclude future bailouts.
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Just-released transcripts of 2008 Federal Reserve policy meetings provide a needed reminder of how Washington dithered as the nation’s financial system nearly collapsed. Has anything happened in the subsequent five years to make a repeat less likely? The U.S. has suffered 14 major banking crises over the past 180 years, as documented by Charles Calomiris and Stephen Haber in their new book, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit, and it has experienced numerous waves of financial reform. And perhaps we’ve finally gotten it right with 2010’s Dodd-Frank legislation, which established a system to wind down failed financial institutions. Banks are no longer supposed to be too big to fail.
But it seems that’s not how Wall Street sees things. The biggest banks have become even bigger since the financial crisis, the financial industry more concentrated. On the surface, at least, it seems banks are acting as if the “too big to fail” safety net continues to exist. The bigger they get, the more likely it is that they can benefit from a government backstop in a crisis.
Perhaps that’s merely wishful thinking on their part. But Calomiris and Haber note that Title II of Dodd-Frank establishes “explicit procedures” for bailing out a TBTF institution. In the next financial crisis, an insolvent megabank will again argue that its failure would bring ruin to the U.S. economy. And the “likely path of least political resistance,” they write, “will be another bailout, rubber-stamped by whichever politicians, judges, or bureaucrats are authorized to approve it.”
Now Wall Street’s megabanks and their Washington lobbyists point out that financial gigantism isn’t a problem everywhere. In Canada, for instance, the banking system is even more concentrated. Yet our neighbor to the north has suffered zero systemic banking crises, ever. Indeed, that nation’s financial sector is renowned internationally for its stability. But the Canadian example should provide no comfort to America. Unlike in the U.S., that nation’s “Big Five” banks are subject to legislative review and rechartering every five years by parliament. Bad behavior and fat profits risk political backlash.
The politics here are quite different, as Calomiris and Haber explain. Early on in our nation’s history, a political alliance between elite-hating agrarian populists and small-time bankers managed to ban interstate banking. The inability to spread risk geographically created an inherently unstable and crisis-prone system. That coalition was eventually replaced by a tag team of megabanks and urban-activist groups. Mergers were approved, and mortgage-underwriting rules were loosened. The result was the creation of megabanks and, eventually, a subprime-lending crisis. The authors have little confidence — given both that history and Dodd-Frank — that as political coalitions evolve, either politicians or regulators will “do much to prevent the next banking crisis.”
The key, then, is to trust rules rather than people. Perhaps the simplest, most transparent approach is to make banks sturdier so the “bailout or no bailout” decision point never arrives. Legislation introduced in the Senate last year by David Vitter, a Louisiana Republican, and Ohio Democrat Sherrod Brown would force megabanks to comply with a 15 percent leverage ratio, meaning they could borrow only 85 percent of the money they lend versus 94 percent or 95 percent under new preliminary U.S bank rules. That size of a capital cushion allowed Wall Street banks to survive the Great Depression, as Calomiris has pointed out, and would have done the same during the Great Recession. Such a requirement, by offsetting TBTF status, might well nudge megabanks into shrinking or breaking themselves up. America’s financial system can be made far more resilient, and it doesn’t take a heavily lobbied, 1,000-page bill to do it.
— James Pethokoukis, a columnist, blogs for the American Enterprise Institute.
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