Wall Street Reform: An Issue of Size or Risk?

Preventing big risks is more important than breaking up big banks.

The phrase “too big to fail” has become a part of our vernacular ever since the Great Recession of 2008/09. For a lot of people, it describes what led to the crisis and indicates the solution: in order to prevent that kind of thing from happening again, we need to break up the big banks.

Over a year ago, Michael Grunwald took a contrarian view in identifying both the problem as well as the solution.

Megabanks just seem scary.

They can be scary. But the main cause of hellacious crises is not overlarge banks. It’s overleveraged banks that make risky bets with borrowed money. Before the panic of 2008, the financial system had a risk problem, not a size problem. The U.S. and international responses to the crisis, quite sensibly, have focused on risk.

If you describe the problem with our financial system as one of size, the solution is easy to articulate (although it would be much more complex to implement) – simply break them up. But focusing on risk as the problem means that things get more complicated from the get-go. That is why it is so difficult to describe and understand the various elements of Dodd-Frank. Here is Nathaniel Popper’s take on that:

From Hollywood, we got “The Big Short” and its judgment, in the words of Ryan Gosling’s character, that “the banks took the money the American people gave them and used it to lobby the Congress to kill big reform.”

I began writing about the industry in early 2010, just after the worst of the crisis passed and right before Congress enacted its landmark effort to clean up Wall Street, what’s now known as Dodd-Frank. I was in Washington when the final version of the law was released. Along with all the discussion about its being the most significant reform of Wall Street since the Great Depression, I remember the confusion as we flipped through the thousands of pages, trying to pick out what would really matter, looking for where the lobbyists had won.

Popper wrote that as part of his introduction to an article titled: “Has Wall Street Been Tamed?” His ultimate goal was to review how Dodd-Frank has affected the financial industry – primarily in the way it takes on risks.

So are they headed toward failure? To judge the likelihood of that, the first thing to consider is what types of risk they’re taking on. And on that front, at least, the changes have been far more notable than most Americans realize. For starters, Dodd-Frank’s “Volcker Rule” forced the banks to get rid of the trading desks where they made enormous speculative bets for their own profit…And this is just one of the risky businesses that the big banks have jettisoned in recent years. The most risky — and profitable — units at all the banks before the crisis were the so-­called fixed-­income divisions, where the banks created and traded bonds and derivatives. In 2006, these departments were the single largest sources of revenue at banks like Goldman Sachs and Morgan Stanley. Today, by contrast, the amount of money the big banks make from their fixed-­income divisions is less than half of what it was at the peak in 2009, and it continues to fall.

How has Dodd-Frank curbed the kinds of risks taken by financial institutions? Popper says it is primarily a result of capital requirements that are designed to incentivize lower risk ventures.

But the greatest engine of change has been some rather arcane accounting rules, known as capital requirements, set by the central banks of governments around the world. Put most simply, capital requirements force banks to raise a specific amount of money (usually from investors) for every dollar they lend or trade. In 2010, central banks agreed that the large commercial banks needed to double or even triple their capital buffers. Riskier ventures require even more capital.

Not only do these capital requirements curtail risk, they are also showing signs of tackling the issue of size.

The Federal Reserve official in charge of these regulations, Daniel Tarullo, was recently called “the most powerful man in banking” by The Wall Street Journal. Tarullo is now pushing to raise the capital requirements even higher for the very largest banks, like JPMorgan and Citigroup, and there are signs that this could do what Bernie Sanders could not: force the biggest banks to split themselves up.

How has this affected the “villain of Wall Street,” Goldman Sachs?

Among the many shrinking banks, one of the most noteworthy is Goldman Sachs, a villain of the crisis and the firm everyone assumed would outsmart the regulators. In large part because of capital requirements and their quieting effect on all sorts of trading, Goldman has slashed staff from the risky, lucrative lines of businesses it used to dominate. Now the firm is focusing its efforts in less risky places, where capital requirements are lower. Its newest products are savings accounts and consumer loans, plebeian products that Goldman would never have deigned to offer before the crisis. The company as a whole has shrunk by nearly a quarter since its peak.

Of course, all of that doesn’t fit neatly on a bumper sticker the way “too big to fail/too big to exist” does. But there is something to be said for effective solutions emanating from the right diagnosis of the problem.

Nancy LeTourneau

Nancy LeTourneau is a contributing writer for the Washington Monthly. Follow her on Twitter @Smartypants60 .