13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (38 page)

However, we think that 4 percent and 2 percent present a reasonable compromise with people who believe that the real economy needs large banks. Members of the Obama administration, as described above, have said that it is impossible to “turn back the clock.” A 4 percent cap would only roll back the clock to the mid-1990s. At that time, the largest commercial banks—Bank of America, Chase Manhattan, Citibank, NationsBank—each had assets roughly equivalent to 3–4 percent of U.S. GDP. On the investment banking side, Goldman Sachs and Morgan Stanley only passed the 2 percent threshold in 1997 and 1996, respectively; at the time, they were the two premier investment banks in the world, and no one thought they were unable to meet their clients’ needs.
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On the one hand, it can be argued that the world has changed since the mid-1990s. But by how much? Thomas Philippon has estimated how much of the growth of the financial sector (measured by its share of GDP) can be explained by increasing demand for corporate financial services from the nonfinancial sector. His analysis shows that demand for finance around 2007, after a spike around 2000, was only 4 percent higher (as a share of GDP) than in the 1986–1995 period (while the corporate finance share of GDP had grown by 31 percent).
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On the other hand, there is no reason why increased demand for finance can only be met by larger firms, rather than more firms. There is also no proof that the mid-1990s economy required commercial banks as large as 4 percent of GDP—which were already the product of what seemed then like blockbuster mergers—or investment banks as large as 2 percent of GDP.

Finally, these size limits would only affect
six banks—
Bank of America (16 percent of GDP), JPMorgan Chase (14 percent), Citigroup (13 percent), Wells Fargo (9 percent), Goldman Sachs (6 percent), and Morgan Stanley (5 percent) (and none of Wells Fargo’s predecessor companies was bigger than 4 percent of GDP until a few years ago).
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Saying that we cannot break up our largest banks is saying that our economic futures depend on these six companies (some of which are in various states of ill health). That thought should frighten us into action.

Some commentators worry that smaller banks would hurt the competitiveness of our financial system; a cap on the size of U.S. banks would lead our banks to relocate overseas and do nothing to prevent the growth of megabanks based in other countries. In an interview, law professor Hal Scott said, “If we break up our banks and Europe doesn’t break up theirs and the Chinese don’t break up theirs, this is going to have an immense impact on who are the players in the international banking system.”
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But this does not mean that American companies would be starved of capital. In a free market, financial intermediation is driven by real economic activity; smaller U.S. banks (and a bank with $500 billion in assets is by no means a small bank), or the U.S. subsidiaries of foreign banks, would step in to fill the gap. U.S. banks already face foreign competition in many financial markets; U.S. companies are perfectly happy buying their interest rate swaps from Deutsche Bank rather than JPMorgan, and the products work just as well.

The more serious issue is not that competition from foreign megabanks will hurt American nonfinancial companies (those foreign banks will be competing
for
the business of U.S. companies), but that foreign megabanks will continue to pose a risk to the global financial system. The ideal solution would be for all major countries to implement similar limits on bank size. One avenue for international coordination could be the World Trade Organization; any government that tolerates domestic banks that are too big to fail is subsidizing them (by allowing them to borrow money more cheaply than foreign competitors that do not have implicit government guarantees), which is a form of protectionism.

However, it is never safe to bet on international agreement, and there is no need for the United States to wait for an international solution. First, U.S. subsidiaries of foreign banks will continue to be subject to U.S. prudential regulation—which should take into account whether that subsidiary would be able to withstand a global financial crisis. If a large European bank were to fail, our financial system would be safer if it did
not
include banks that were too big to fail; the whole point of size limits is to increase the ability of the system to withstand a shock, no matter where it originates. And if European countries want to keep banks that are too big to fail, then their taxpayers will have to bail them out in case of a crisis. In effect, foreign governments would be taking on the role of insuring the global financial system against disaster—a role that the Federal Reserve and the Treasury Department played in 2008–2009.

Relying on foreign government bailouts alone would not make us invulnerable to crises originating overseas. For example, Switzerland may not be able to afford to bail out UBS should it suffer a major crisis. For this reason, our financial regulators need to evaluate the potential risks created by foreign megabanks and, if necessary, take action to limit our exposure to those banks. But in any case, we would be less exposed than we are today. And the way to start is to create a financial system that is not vulnerable to the collapse of a few towering dominoes.

A real cap on bank size will not only level the economic playing field and reduce the incentive for banks to take excess risks predicated on the government safety net, but it will also weaken the political power of the big banks and begin to undo the takeover of Washington by Wall Street that we have chronicled in this book. Without a privileged inner core of thirteen (or fewer) bankers, the financial sector will be composed of thousands of small companies and dozens or hundreds of medium-to-large companies, including hedge funds and private equity firms. The financial lobby will continue to be strong by virtue of its sheer size, and the community bankers will retain their clout in Congress. But the distortion of the playing field in favor of a small number of megabanks will come to an end.

This fragmentation of the banking industry should also help dethrone Wall Street from its privileged place in the U.S. economy. The end of “too big to fail” will reduce large banks’ funding advantage, forcing them to compete on the basis of products, price, and service rather than implicit government subsidies. Increased competition will reduce the margins on fee-driven businesses such as securitization, trading, and derivatives, putting pressure on large banks’ profits. A larger group of competitors will also make it harder for major banks to divert such a large proportion of their profits to employee compensation; bonuses for traders and investment bankers should fall from the historically obscene to the merely outrageous. With more competition, it will be harder for a handful of firms to dominate the cultural landscape like Salomon Brothers and Drexel Burnham Lambert in the 1980s or Goldman Sachs today, and perhaps smart college graduates will find Wall Street a little less compelling. Finance will never go back to being boring—globalization and computers have seen to that—but it should become a little less exciting.

This will create a virtuous cycle. As the major banks become a little poorer, their domination of the campaign finance system will wane, as will the allure of the revolving door. As high finance becomes less glamorous and a little more like just another business, its ideological sway over the Washington establishment will begin to fade. Fewer top administration officials will come from a handful of megabanks, and more will come from other parts of the financial industry, or from nonfinancial industries. The financial crisis has made at least some people think that everything is not right with the Wall Street view of the world; weakening the big banks will help fuel that healthy skepticism. Finance will never be just another industry. It is too big and too central to the economy, and there is something seductive about a business that deals in nothing but money. But reducing the size, profits, and power of the big banks will begin to restore balance both to our economy and to our political system.

These ideas will not be adopted overnight. In 1900, almost no reasonable person thought there was any basis for capping the size of private businesses—no well-developed economic theory supporting such a position, no common law tradition, and nothing in the U.S. Constitution (as interpreted by the Supreme Court).
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When Theodore Roosevelt sued Northern Securities in 1902, the conventional wisdom was that the industrial trusts were a fact of nature. There was little precedent for the idea of using the Sherman Antitrust Act against a large corporation (although it was used against labor unions in the 1890s). In addition, the trusts had strong backers in Washington, including the key power brokers in Roosevelt’s own Republican Party. For Roosevelt, however, any economic benefits that might be provided by the trusts did not outweigh the costs they imposed on society, both by charging monopoly prices and by stifling competition.

By 1910, the consensus view had shifted dramatically. The power of the industrial trusts and the details of their anticompetitive behavior were sufficiently obvious to provoke a political backlash. The middle class became afraid that its hard-won status and relative affluence were endangered by the rise of the super-rich, and that increasing economic inequality would undermine the dream of upward mobility. Because President Roosevelt was willing to confront the trusts, he helped change the conventional wisdom. That change was also shaped by the findings of the Pujo Committee and the writings of Louis Brandeis. And the shift in the consensus was a major reason why the antitrust movement had such lasting effect; today, few people think that unrestrained monopolies are good either for our economy or for our political system.

Our goal today is to change the conventional wisdom about enormous banks. In the long term, the most effective constraint on the financial sector is public opinion. Today, anyone proposing to end the regulation of pharmaceuticals or to suspend government supervision of nuclear power stations would not be taken seriously. Our democratic system allows the expression of all views, but we filter those views based on a collective assessment of which are sensible and which are not. The best defense against a massive financial crisis is a popular consensus that too big to fail is too big to exist.

This is at its heart a question of politics, not of economics or of regulatory technicalities. The challenge we face today is similar to the one faced by President Roosevelt a century ago; the antitrust movement was originally a
political
movement, although today antitrust law has become a field for technocratic analysis of pricing power and consumer welfare.
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The conventional wisdom, shaped during the three decades of deregulation, innovation, and risk-taking that brought us the recent financial crisis, is that large, sophisticated banks are a critical pillar of economic prosperity. That conventional wisdom has entrenched itself in Washington, where administration officials, regulators, and legislators agree with the Wall Street line on intellectual grounds, or see their personal interests (financial or political) aligned with the interests of Wall Street, or simply do not feel qualified to question the experts in the thousand-dollar suits. Challenging this ideology is ultimately about politics. The megabanks used political power to obtain their license to gamble with other people’s money; taking that license away requires confronting that power head-on. It requires a decision that the economic and political power of the new financial oligarchy is dangerous both to economic prosperity and to the democracy that is supposed to ensure that government policies serve the greater good of society.

The Obama administration and Congress have so far chosen to dance around this confrontation. It remains too early to tell if occasional outbursts of anti–Wall Street rhetoric will translate into substantive reform. It is likely that our government will use this legislative cycle to declare victory over the financial crisis, without addressing its most fundamental cause. The result will be a financial sector that is more concentrated than ever, has a more robust guarantee of government assistance than ever, and takes more risks than ever. With the same conditions in place that led to the last financial crisis, it would be folly to expect any other result. No one can predict what market will produce the next financial crisis, or when it will occur, but no one with any memory should bet against it. And when that crisis comes, the government will face the same choice it faced in 2008: to bail out a banking system that has grown even larger and more concentrated, or to let it collapse and risk an economic disaster.

But there is another choice: the choice to finish the job that Roosevelt began a century ago, and to take a stand against concentrated financial power just as he took a stand against concentrated industrial power. That is a choice that Barack Obama could make. It is a choice that the American people need to make—and sooner rather than later. The Panic of 1907 only led to the reforms of the 1930s by way of the 1929 crash and the Great Depression. We hope that a similar calamity will not be a prerequisite to action again.

Even when it goes out of fashion, Thomas Jefferson’s suspicion of concentrated power remains an essential thread in the fabric of American democracy. The financial crisis of 2007–2009 has made Jefferson a little less out of fashion. It is that tradition of skepticism that, if anything, can shift the weight of public opinion against our new financial oligarchy—the most law-abiding, hardworking, eloquent, well-dressed oligarchy in the history of politics. It is to help reinvigorate that spirit of Jefferson that we have written this book.

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This problem can be mitigated through collateral requirements, which mean that if a derivatives trade moves against one party, it has to give collateral to the other party to protect against its own failure. However, it is not feasible to fully collateralize a credit default swap, because when a bond defaults the value of a credit default swap on that bond suddenly jumps to almost the full face value of the bond.