Too Big for Us to Fail

Financial regulatory reform was on few people's minds when Barack Obama launched his presidential campaign in February 2007. But with the near collapse of the global financial system in 2008, leading to high unemployment and high government deficits for years to come, it became frighteningly obvious that something had to change. However, in one respect -- the politics of financial reform -- nothing has changed.

The Obama administration has led the push to reform the financial system. We agree with many of its proposals, including a strong Consumer Financial Protection Agency, dedicated oversight of systemic risk, and new requirements to move derivatives onto exchanges and central clearinghouses. At the same time, we do not think the administration has gone far enough to curb the behavior of "too big to fail" institutions and mitigate the risk that they pose to the financial system and the economy. But these reasonable debates over how the regulatory system should be overhauled are peripheral to a more fundamental issue: the political power of the financial sector, which determines how the regulatory system will be overhauled, if at all.

The growth of the megabanks, the rapid spread of financial "innovation," the excessive risk-taking of the past decade, and the financial crisis were not purely economic phenomena. They had deeply political roots, in the deregulatory philosophy of the Reagan Revolution and the ideology of finance spawned by free-market economists. And the big profits on Wall Street were made possible in the halls of power in Washington.

From the Garn St.-Germain Act of 1982 (substantially deregulating savings and loan institutions) to the Gramm-Leach-Bliley Act of 1999 (allowing combined commercial and investment baking) and the Commodity Futures Modernization Act of 2000 (permitting largely unrestricted trading in derivatives), Congress relaxed the regulatory constraints that had housebroken the financial industry since the 1930s, while failing to establish effective oversight of custom derivatives. The Federal Reserve spent the 1990s relaxing constraints on commercial banks and the 2000s neglecting to enforce consumer-protection laws against predatory mortgage lenders. In 2004, the Securities and Exchange Commission relaxed capital requirements for major investment banks in exchange for the power to oversee them through the Consolidated Supervised Entity program -- a program that failed spectacularly with both Bear Stearns and Lehman Brothers.


The core failure of the past 30 years was not that Wall Street financial engineers thought of clever ways to make money; that is absolutely par for the course. The failure was that Wall Street was able to gain sufficient influence in Washington to win favorable policies from Congress, regulators, and both Democratic and Republican administrations. The banks earned their political power the old-fashioned way, through campaign contributions and lobbying expenditures; the financial sector was the primary source of campaign money for the past two decades, and its contributions grew disproportionately rapidly over the period. More important, the popularization and spread of the ideology of finance meant that politicians and government officials increasingly came to sincerely believe that what was good for Wall Street was good for America.

The collapse of Lehman Brothers and the near failures of Morgan Stanley and Goldman Sachs -- chronicled in detail in Andrew Ross Sorkin's Too Big to Fail -- should have shaken this belief. The recent report by Anton Valukas, the examiner in the Lehman bankruptcy, revealing a history of (at best) misleading accounting and lax government oversight, should have obliterated its remains. But although Washington is more willing to regulate now than in years past, one thing has emphatically not changed: the power of the banking industry to fight back. All of the techniques honed over the past few decades have been evident in full force over the past year.

One technique is the use of complexity. The modern financial world is complex, and most of the experts work on or for Wall Street. When it comes time to draft new legislation governing highly technical topics such as derivatives, those insiders have a clear advantage over most congressional staffers. In November, William Greider described how derivatives dealers wrote the draft legislation reforming regulation of derivatives and funneled it into Congress via conservative Democrats on the House Financial Services Committee. Administration officials such as Gary Gensler, chair of the U.S. Commodity Futures Trading Commission, have fought to close the loopholes in that draft bill, but the Senate bill introduced by Christopher Dodd in March contains its own new exemptions.

Another technique is to hide behind "ordinary people." During the boom years, one major argument for financial innovation was that it increased homeownership -- a tenet subscribed to by both the Bill Clinton and George W. Bush administrations. Early in 2009, the American Bankers Association opposed legislation giving bankruptcy judges the power to modify the terms of mortgages on the grounds that it would "make home loans more expensive and less available for consumers." As the legislative battle heated up in the summer and fall, the financial lobby rolled out "end users" of derivatives -- corporations that use options or futures for legitimate hedging of risks -- to testify against regulatory reform. The U.S. Chamber of Commerce pitched in with advertisements warning ominously that stronger consumer-protection rules would be bad for American business.

The framing of the argument has changed. It is no longer that unrestricted finance will bring benefits to all Americans; it is now that restricting finance will actively cause harm to Americans. In effect, the financial sector is attempting to hold the economy hostage yet again. Handcuff the banks, for example, by making it harder to increase interest rates on credit-card customers, and many people will lose access to credit. Or so the threat goes.

Even as the ideology of deregulation has been exposed as a failure, the banks and their political allies are still invoking the bogeyman of big government to fight off financial reform. Political consultant Frank Luntz clearly spelled out the strategy to demonize reform by branding it as more bureaucracy, bailouts, and special-interest loopholes. This has created the Orwellian specter of Republicans introducing special-interest loopholes into reform legislation (such as an exemption for automobile dealers from the proposed Consumer Financial Protection Agency, introduced by Rep. John Campbell, a Republican) and then criticizing the same legislation for its loopholes.

Journalists Ryan Grim and Arthur Delaney have documented how Democrats have placed new, relatively conservative members of Congress from Republican-leaning districts on the House Financial Services Committee, because it increases their ability to raise money. Unfortunately, the effect was to create an influential bloc of banking-friendly Democrats on the committee, who allied with Republicans on certain issues to weaken financial-reform legislation, against the wishes of committee Chair Barney Frank.

At the same time, lobbying by the financial sector has reached record levels. According to data collected by the Center for Responsive Politics, the finance, insurance, and real-estate sector spent over $463 million on lobbying in 2009, the most ever. (The banking and securities industries were responsible for $144 million of that total, also a record.) Even Citigroup spent over $5 million on lobbying -- although the government was its largest shareholder.

In sum, though the financial crisis hurt the megabanks' profits (for a quarter or two, at least), it did nothing to weaken their political power. If anything, increased concentration only increased the stature and influence of the survivors, and the Supreme Court's 2009 decision in Citizens United put politicians on notice that corporate influence over politics is likely only to grow


What would it take to curb the political power of the financial sector? Grass-roots campaigns, such as the Move Your Money campaign to take money out of large banks, could have a small impact. New laws or constitutional amendments to restrict the role of money in politics would certainly help. Restrictions on compensation, by making banking less lucrative and less alluring, would help reduce the ideological hegemony of Wall Street. Breaking up the megabanks, by increasing competition and increasing the costs of collective action, would help most of all.

Ultimately this will come down to a battle of ideas, one that will take years to win. As long as people think that finance is inherently good and big finance is inherently better, Washington will remain easily swayed by Wall Street. The political power of the banking industry is not simply a product of its deep pockets; imagine, for example, how much harder and more expensive it would be for the tobacco industry to dominate Washington. Tobacco once had far more power than it does today. Its diminished influence shows the influence of citizen and government efforts -- a story that should give us hope that finance can also be constrained.

We should not think of finance as the pride and joy of our economy but as something like a regulated utility (an industry on which the economy depends but that should be watched over carefully) and something like big tobacco (an industry that makes toxic products with huge negative externalities). Shifting the conventional wisdom in this direction will be a prerequisite for fundamental reform of both the financial system and the political system in the long term.

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