If a Financial Institution is Too Big to Fail, It's Just Too Big
The Obama Administration's new proposals to expand the Federal oversight of the nation's financial institutions represent a fundamental departure from the "hands off" policies of the Bush years that allowed last fall's financial collapse. They are critically important to the long-term financial security of our economy and working families.
They also offer the opportunity for us to once again consider the overall structure of the financial services industry itself. Last fall's financial panic raises anew a long-running issue in American politics: how big should financial institutions be allowed to grow?
To most Americans the answer is clear: if a financial institution is too big to fail, it's just too big.
From Andrew Jackson to Williams Jennings Bryant to Teddy Roosevelt and FDR, the battle over size and power of banks and other financial institutions has been a theme that has run throughout American history. The reason is simple. The larger a financial institution becomes, the greater its power to control the lives and futures of ordinary Americans. Of course, that power is never demonstrated so graphically as in times of financial collapse, when the excesses of unregulated markets and supersized financial empires implode on the entire economy.
Elizabeth Warren, who chairs the panel appointed by Congress to oversee the bank bailout legislation, points out that the first "credit freeze" - or American financial panic - occurred in 1792, not long after the new country was founded. A credit collapse then occurred roughly every 15 years until the Great Depression, when at long last the Federal Government seriously intervened to regulate the private financial market.
The Federal Deposit Insurance Corporation (FDIC) was created to guarantee bank deposits, put a halt to "runs on banks," and specify bank reserve requirements. The Security and Exchange Commission regulated the stock market - and greatly increased transparency. And the Glass-Stiegle Act was passed to prevent banks from branching out into other speculative arenas that might endanger their solvency.
These three provisions - coupled with Keynesian fiscal policy and more aggressive use of monetary tools by the Federal Reserve - broke the every-15-year cycle and effectively prevented a nation-wide financial meltdown for the next half century.
But then, the deregulation of the Savings and Loan industry in the 1980's lead to the failure of hundred of thrift institutions and the collapse of property values. As if that were not enough, the increasingly powerful financial sector then managed to convince Congress to repeal the Glass-Stiegle Act during the 1990's.
The result has been massive consolidation of power by a few major financial institutions that have ranged far afield from banking into highly speculative activities of all sorts. Brokerage firms like Goldman Sachs and banks like CitiBank have become indistinguishable. Massive portions of the credit market now exist outside of the oversight of any regulator.
Today, 45% of the banking market in the U.S. is dominated by Bank of America and CitiBank. The rescue of companies like AIG was justified because its size, and because the interconnectedness of its financial transactions, made its failure pose a "systemic risk."
But the fact is, there is no good economic rationale for the massive size of today's financial institutions - or for the massive growth of the financial sector in general.
Often, those who advocate allowing unlimited corporate growth argue for the advantages of economies of scale. But once you look at the actual functions of financial institutions in the economy these arguments fall flat.
There are really three useful economic functions served by financial service institutions:
First, they are supposed to aggregate and reinvest savings; second, they are intended to allocate risk; finally, they provide products that can increase convenience and efficiency.
Of course our financial institutions also provide the opportunity for a relatively small group of Wall Street insiders to place gigantic bets - to gamble for stakes far higher than those available at the gaming tables of Las Vegas or Atlantic City. As far as I am concerned, gaming in Vegas has fine entertainment value, but providing a gigantic worldwide casino for the rich is not an economically vital core function for the world's financial markets.
None of the three true core functions of financial institutions requires the massive size that allows the domination of the market place. In fact, the monopoly power and threat of instability that comes with that size itself threatens our economy. As they grow, these private sector players wield far too much power - hitherto mostly unregulated by democratic institutions -- and leave us all vulnerable to the bad decisions, excesses and mistakes of a small number of unaccountable decision-makers.
We don't need massive financial institutions to aggregate large sums of capital for major projects. The publicly-traded financial markets themselves provide the means of doing so through transparent markets structures rather than backroom decisions by giant financial firms or private hedge funds shielded from public view.
The true innovations in financial products that bring us more convenience - like ATM's, electronic funds transfers, and online banking can be achieved just as easily through the Internet and Federal Reserve if we had thousands of banks, than it can with just a few.
Far from allocating risk so that the overall econ omy is more secure, the giant firms that operate increasingly out of the public view have transferred risk from themselves to the taxpayers. The recent government bank subsidies make this clear. They have created bonus structures like those at AIG, that give huge payoffs if financial bets are successful and no down side if they fail. In fact, as we now see in the case of AIG and many other financial institutions, they apparently generate huge payoffs even when their bets precipitate the collapse of the entire economy.
They have created more and more derivatives and other exotic financial products because each time an underlying asset is sliced, diced and resold they harvest the "golden crumbs." Those crumbs are the fees that, taken together, allow them to siphon more and more money into an increasingly bloated financial sector from the pockets of people who actually create products and services in the real economy. This is one of chief reasons why all of the economic growth of the last eight years has gone to the top 2% of the population, and why the real income of average Americans has not increased since 1972. It is also one of the chief reasons why the economy has fallen off a cliff. As any Economics 101 student can tell you - if potential customers don't have money in their pockets to buy products, economic growth comes to a crashing halt.
The financial sector has doubled in size over the last 14 years. Its percentage of the GDP has skyrocketed. This huge wealth transfer from the "real" economy to the world of finance has created a vicious cycle of increased credit dependency. If your family's real income isn't going up, but costs are, you try to borrow to stay afloat. That is one reason why private debt now equals 350% of the Gross Domestic Product - the highest ever. The more debt that consumers owe to the shrinking number of big financial institutions, the greater the share of their shrinking or stagnant inc omes is siphoned off to the finance sector - and the cycle just gets worse.
It is clearly time to regulate the entire world of finance, as Secretary Geithner has proposed. It is also time to break up the CitiBank's, Bank of America's, and AIG's of the world.
And it is time to shrink the entire financial sector. This last goal will require an end to the anything-goes "Dodge City" mentality that allows consumers to have their pockets picked by financial "products" like teaser-rate mortgages with prepayment penalties that guarantee the consumer pays more than meets the eye. It will require tight regulation of credit card interest rates and fees. It will require oversight of the "derivatives" and "credit-default-swap" markets.
Serious regulation will inevitably cut back on the flow of income from normal people to banks and the financial sector as a whole - and that's something that is long overdue.