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Updated on Monday, April 27, 2015
In April, both Senator Elizabeth Warren and former Federal Reserve Chair Paul Volcker announced proposals to reform the financial system. Warren and Volcker have very different approaches, but their timing is not a coincidence. Thought leaders are becoming increasingly concerned about a lack of meaningful reform to the financial system after the crisis of 2008. Banks that were “too big to fail” have become larger. The pre-crisis regulatory regime was excessively complex, creating loopholes and unintended consequences. Yet the post-crisis environment has become even more complicated. It is highly unlikely that either of their proposals will be enacted. However, their views will certainly influence the debate.
Warren Wants To Shrink The Banks
Senator Warren released her plan here, and it is summarized below:
- Expand the Consumer Financial Protection Bureau (“CFPB”) oversight to include auto dealers.
- Cap the size of financial institutions. By default, this would force a number of large banks to shrink.
- Reinstate the barrier between commercial banking and investment banking.
- Implement a financial transaction tax.
- Limit the ability of banks to deduct interest and executive bonus payments from corporate taxes.
Senator Warren believes that banks are too large, do too many things and pay their employees too much. Her reform proposals look to shrink the banking system, limit the activities of banks and make it more expensive to pay employees big salaries. However, her proposal has already received challenges.
There is no doubt that banks have become monstrously large. The four biggest banks have balance sheets in the trillions of dollars. However, an arbitrary asset size restriction may not be sufficient to limit risk. During the financial crisis, smaller organizations that took bad bets on mortgages started a domino effect that crushed other financial institutions.
Reinstating the barrier between commercial and investment banking sounds appealing, but it also has limitations. Lehman Brothers brought the financial system to its knees. But it did not take FDIC insured deposits. Lehman’s losses were amplified because of the interconnectedness of the banking sector. Reinstating Glass-Steagall would probably not have prevented Lehman Brothers from taking disastrous mortgage bets.
Going after executive pay is popular. However, just taxing executive compensation will likely be insufficient to change management behavior.
And Senator Warren has talked about making banking more “boring.” That means taking consumer deposits and making loans. However, the history of “boring” banking is a history of crisis. During the Savings and Loan crisis of the 1980s, extremely boring banks required massive taxpayer bailouts.
Volcker Wants A Simpler Regulatory Structure
Paul Volcker focused, instead, on the structure of the regulatory environment. He believes that the regulatory environment is “highly fragmented, outdated and ineffective.” He wants to simplify and strengthen the regulatory environment by:
- Combining the Securities and Exchange Commission (SEC) with the Commodities Futures Trading Commission
- Establishing a new independent agency, the Prudential Supervisory Authority. This would consolidate the work of the FDIC and OCC into one regulator.
Volcker rightly points out that the complicated regulatory structure creates loopholes and unintended consequences. Entire industries can be created that exploit regulatory loopholes, and regulators can be too slow to respond.
Hopefully We Have A Debate
After the financial crisis, Dodd-Frank was passed to reform the financial services sector. Some provisions have been praised as necessary. For example, the FDIC was given authority to liquidate nonbank financial companies. That authority would have been very helpful during the financial crisis.
However, the act created more regulatory agencies, rather than sharpening the remit of existing agencies. And the bill became incredibly complex. The bill was 848 pages long. The original Glass-Steagall act was only 37 pages. And thousands of pages of rules have been written to implement Dodd-Frank. As The Economist reported, just one form required by Dodd-Frank ran 192 pages long. Complexity is the enemy of transparency. The more complicated the rules, the more likely something can be created to avoid them.
The good news is that people are starting to talk about financial reform. Despite the new rules, new regulatory agencies and new disclosures, there is still a lot of work to be done. However, real action only seems to happen when there is a crisis. Senator Warren and Paul Volcker both hope to stir discussion, especially as the presidential election looms closer.
Bank reform is a complicated issue. There are still widespread debates about the cause of the crisis. And the solution still feels incomplete. Hopefully another financial crisis isn’t required for the next batch of reform.