AP Photo/Jae C. Hong
Members of the Federal Reserve don't usually make the rounds at partisan gatherings. But amid the tri-cornered hats and "#StandWithRand" buttons of last week's Conservative Political Action Conference (CPAC)-the largest annual gathering of conservatives in the country-was Richard Fisher, president of the Dallas Federal Reserve Bank. In a Saturday morning speech, Fisher quoted Revolutionary War hero Patrick Henry, who once said that while "Different men often see the same subject in different lights," such quibbling had to be set aside in a time of "awful moment to this country."
Fisher described the current time as an era of economic injustice in which the nation's largest banks threaten our financial stability and act with immunity. He said that the Dodd-Frank financial reform law did not go nearly far enough to fix the problem, and that mega-banks still profited from being "Too Big to Fail." His solutions included a proposal to limit the total assets held by the biggest financial institutions, keeping them at a size that would make them "small enough to save." And he called on citizens of all political stripes to join him in this cause. "The American people will be grateful to whoever liberates them from a recurrence of taxpayer bailouts," Fisher concluded. It was an indication of just how bipartisan the support for breaking up the big banks has become.
It may be surprising that conservatives-whose party just ran a private-equity tycoon for president-would be clamoring for Wall Street banks to be cut down to size. But over the last few years, conservative intellectuals-from economists and central bankers to think-tankers and high-profile pundits-have come to the conclusion that the largest institutions remain Too Big to Fail and that, in ways big and small, receive unfair financial advantages over their smaller rivals. This sort of sentiment on the right is of course not new; the Tea Party was propelled by anger against bailouts. But what is new is the rare alignment of the ivory tower and the grassroots. What's more, these forces have penetrated the Beltway: Senate Democrats and Republicans are actively discussing legislation that would cap the size of banks, impose higher capital requirements, and separate commercial bank functions-taking deposits and making loans-from investment activities. With all the current gridlock in Congress, breaking up the banks may actually represent a rare moment of agreement between the right and left.
The roots of this emerging consensus starts with the 2008 financial crisis, whose subsequent $700 billion bailout of Wall Street's major financial institutions touched off frustration and anger across the political spectrum. Fueled by a deep skepticism of elites, the grass roots on both the right and left-the Tea Party, Occupy Wall Street-railed against the spectacle of taxpayer dollars handed to irresponsible institutions that caused the Great Recession.
The Tea Party's critique and the conservative academic diagnosis serve as a kind of a funhouse-mirror version of the way liberals talk about these issues. Rather than assailing corporate malfeasance, conservatives talk about government overreach. Fundamentally, what drives opposition to banks on the right is the sense that government has rigged the game to "pick winners and losers" by delivering giant subsidies to the nation's biggest banks and, after they get so big their collapse threatens the entire financial system, bailing them out when they run into trouble. "I've talked about this issue in more town hall meetings than maybe any Republican. There's been a serious erosion of trust in our institutions of power," former Utah Governor and presidential candidate Jon Huntsman said at a panel discussion in Washington earlier this month, "and that's directly tied to this whole subsidy issue." The theory is simple: If investors believe a mega-bank will get bailed out if it gets into trouble, without any losses forced on creditors, they have more confidence in lending to them than their smaller rivals, giving them a competitive advantage and incentivizing them to grow large.
You can quantify the subsidy by calculating the cost of funding for the biggest banks relative to community or regional banks. A recent study by the International Monetary Fund showed that mega-banks borrow about 0.8 percent more cheaply than their smaller rivals. According to a Bloomberg analysis of the findings, this amounts to a taxpayer subsidy of $83 billion a year, equalling virtually all of the annual profits enjoyed by the largest banks. Some have quibbled with the $83 billion number, but nobody but the banking industry doubts the reality of the subsidy; in fact, some put the number higher. Fisher noted in his CPAC speech that this creates an unlevel playing field for the biggest banks, who are favored by creditors. "Why should a prospective purchaser of bank debt practice due diligence if, in the end ... it is widely perceived that the issuing institution will not be allowed to fail?"
It's hard to argue with the evidence as to bank size. The nation's six top banks, which held assets equaling 18 percent of GDP in 1995, have now ballooned to 63 percent of GDP. And since the 2008 financial crisis, the banks that caused it have grown in size by between 20-25 percent thanks to a series of hastily arranged mergers and government-run, emergency-lending vehicles that nursed them back to profitability. Conservative Thomas Hoenig, whom Republicans nominated as vice chair of the Federal Deposit Insurance Corporation (FDIC), has measured U.S. mega-banks using the same accounting standard used in Europe, which places the full risk of derivatives trades on the balance sheet. Under this standard, three U.S. banks-Bank of America, J.P. Morgan Chase, and Citi-are the three largest banks in the world.
This gives these mega-banks such a dominant position in the economy that they are virtually guaranteed to receive a bailout rather than be allowed to fail. "Big banks have too much power. In the middle of a crisis, no official wants to be the one who failed to save the financial system," argues conservative Arnold Kling of George Mason University, who has been out front on the need to break up mega-banks.
In addition, the availability of cheap debt allows mega-banks to finance their operations through borrowing instead of equity. Hoenig's apples-to-apples balance-sheet comparison of the U.S. mega-banks shows that they have an average capital ratio of 3.68 percent; for every $100 a mega-bank lends out, it borrows $97 and holds only $3 in stock or cash reserves. "That means that a 3.7 percent drop in the value of assets would cause the banks to be insolvent," said Neil Barofsky, former Special Inspector General of the TARP bailout program.
So not only does power get concentrated in the hands of a few financial firms, but those firms are encouraged by the implicit subsidies to take on outsized risks, and are assured of a bailout if things go awry. "If you're an institution and you think you can have a lot of leverage and put it on the government if it goes bad, you're going to have a lot of risk," explains Sheila Bair, a Republican and former chair of the FDIC. Conservatives say this scheme undermines economic freedom and makes it impossible for the market to function properly to reward prudence and discipline recklessness. "By breaking up the biggest banks, conservatives will not be putting asunder what the free market has joined together," argued conservative pundit George Will in a recent column. "Government nurtured these behemoths by weaving an improvident safety net and by practicing crony capitalism."
It is not just pundits who see the problem: The list of conservative economists who share this view is quite comprehensive, from Nobel Prize winner Ed Prescott and Glenn Hubbard to the late Milton Friedman co-author Anna Schwartz, and Luigi Zingales.
They agree on both the nature of the problem, and that technocratic regulatory fixes like Dodd-Frank will not solve the problem. Classical Chicago School economists like George Stigler argued that interest groups would dominate regulatory agencies and use them to advance their commercial interests, a theory known as "regulatory capture." Regulators are both outgunned and simply confused by the stunning complexity of mega-bank activities. And law enforcement has been intimidated into letting banks off the hook for a seemingly unending series of criminal scandals. Attorney General Eric Holder recently admitted in Congressional testimony that the size of the largest banks has a material effect on this no-prosecution stance, telling senators that "if you do bring a criminal charge, it will have a negative impact on the national economy."
The problem on both the right and left has long been translating the fervor against the mega-banks into action. The Tea Party's sole prescription for solving Too Big to Fail was to simply let banks collapse. But conservative academics, despite their belief in regulatory capture, are more comfortable than the conservative grass roots with setting up simple rules that would eliminate subsidies, reduce bank size and end Too Big to Fail. "It's not possible to let all banks fail if it's a systemic issue," says Jim Pethokoukis of the American Enterprise Institute, who wrote one of the definitive conservative briefs for breaking up the banks in The Weekly Standard last year. "It's appropriate to counteract it through government policy, in trying to restore market forces and competition."
In favoring these policies, conservatives are re-connecting with their inner populist, defying the stereotype that Republicans support the banking establishment and abhor any regulation on industry. "If you are conservative you are skeptical of concentrated power," said former Reagan speechwriter Peggy Noonan in an op-ed in The Wall Street Journal. "Republicans should go to the populist right on the issue of bank breakup."
The new surge of interest in ending Too Big to Fail on the right has converged with an existing effort on the left, and it's translating into legislative action. Sherrod Brown, the populist progressive senator who just won re-election in Ohio, has been discussing solutions to the mega-bank problem with up to ten Republican senators. Against all expectations, his main partner is David Vitter, a Republican and fellow member of the Senate Banking Committee. "I looked across the committee room one day, he was questioning [Treasury Secretary] Ben Bernanke," said Brown in an interview about his Republican colleague. "He was really tough on higher capital standards. I figured he could be an ally, he did have a concern that banks were too big, too economically powerful and too politically powerful."
The unlikely duo began working several months ago. They started by urging the Federal Reserve and other regulators to use their power to increase capital standards on the largest banks, which typically deal in riskier activities and therefore require more of a backstop. The idea of forcing banks to cover their own responsibilities has been bolstered by a recent book from economists Anat Admati and Martin Hellwig called The Bankers' New Clothes, which endorses stronger capital standards and has earned praise on the left and right. Bank capital rules, based on international standards and modified by national regulators, are often impenetrable and easily gamed through fancy accounting; Brown and Vitter would like to see the rules simplified. "Wall Street banks-not Main Street taxpayers-should be on the hook for their own mistakes," Brown and Vitter wrote.
In January, Brown and Vitter unanimously passed legislation on the Senate floor requiring the nonpartisan Government Accountability Office (GAO) to conduct a study to determine whether mega-banks enjoy borrowing subsidies from their Too Big to Fail status, the subsidy conservatives believe to be at the heart of the problem. While the House never took it up, GAO agreed to conduct the study. GAO's reputation as an authoritative source in Washington could change the political dynamic on the subsidy question. "We may see more support for dealing with this after the GAO study," says Jim Pethokoukis. "It could free up those supporting quietly to be more vocal."
At the end of February, Brown and Vitter announced they would work on legislation to incorporate much of the thinking about how to deal with runaway banks. Brown tried this once with an amendment to Dodd-Frank with Senator Ted Kaufman that would have capped mega-bank assets to a percentage of GDP. It received 33 votes in 2010, with only 3 Republicans supporting. Brown's discussions with colleagues leave him thinking Brown-Kaufman could get at least 50 votes today, and the bipartisan nature of the Brown-Vitter effort could mean that whatever results will have an even better chance at broad support. In a floor speech announcing their joint effort, Vitter said, "I don't know if we quite define the political spectrum of the United States Senate, but we come pretty darned close. And yet, we absolutely agree about this threat."
Vitter has a stated interest in tightening capital requirements, but Brown's ideas on capping bank size, will play a part in the legislative discussions as well. Brown and Vitter are looking at other options from across the political spectrum. For example, conservative Thomas Hoenig of the FDIC believes that the safety net for banks has grown too large, and should be confined to the commercial banking system. "Spin the higher-risk trading activities out to a different organization, so the safety net is not directly exposed to those institutions," Hoenig opines. Incredibly, this is now the position of former Citigroup head Sanford Weill, whose bank lobbied to eliminate the Depression-era Glass-Steagall Act, which set up separations between commercial and investment banks. Jon Huntsman and Sheila Bair want to see a fee assessed on Too Big to Fail banks to cover the implicit subsidy from lower costs to funding in the market.
"We're working all of these ideas on separate tracks," Senator Brown said. He wants to build support across all these ideas: breaking up banks, ramping up capital standards, dealing with the implicit subsidy, and walling off commercial and investment activities. He believes that each advance helps the other, and that with such a entrenched problem, attacking on all angles is the most prudent strategy, increasing the odds that one reform actually might get through.
Despite the convergence of opinion between the grassroots, conservative thinkers, and lawmakers, the obstacles to reform are obvious. Financial institutions didn't grow to their current size without obtaining substantial political power. Wall Street showers lawmakers with contributions and lobbies against any restrictions on their activities in the legislative or regulatory sphere. More important, government officials constantly hear and internalize the industry perspective on financial issues, a "cognitive capture" that sidelines reform voices. "This town sings with an upper-class accent," quips Sherrod Brown.
This is a particular problem for conservatives wanting to change their party's dominant viewpoint, even if it would help minimize the perception that Republicans are the party of bankers and the one percent. "I interviewed Mitt Romney during the campaign and asked him about this," says Pethokoukis. "He was simply not aware of a problem with bank size. He just wasn't prepared to answer."
Complicating this further is the fundraising advantage Republicans gained from Wall Street in 2012, a reversal from 2008. Conservative Matthew Continetti writes of a double bind for Republicans. Policies that may be attractive to the public, like breaking up the banks, contrast directly with institutional funding sources for Republican campaigns. Already, a backlash to the populist surge against the banks is forming on the right; a consulting firm called Hamilton Place Strategies (made up of aides to the last three Republican Presidential nominees) released a paper last month arguing in favor of big banks' role in society.
But the academic conservative consensus has at least broken through the industry talking points and gotten traction on Capitol Hill. As a party, the GOP has recently been more responsive to its grassroots.
That's the dynamic we saw during Rand Paul's recent 13-hour filibuster. Neoconservatives objected to Paul's more isolationist, civil-libertarian stance against targeted killing policies, but within hours, practically every Senate Republican enthusiastically endorsed Paul's filibuster-even Minority Leader Mitch McConnell. Because Republicans fear their base, if the base clamors for a crackdown on Wall Street banks, the political dynamic could work in favor of the reformers, even if big-money contributors object.
This was evident in previous trans-partisan coalitions during the Dodd-Frank debate, particularly in the movement to audit the Federal Reserve, led by liberal firebrand Alan Grayson and libertarian Ron Paul. In one of the only truly bipartisan successes of the Obama era, Grayson-Paul passed both houses of Congress with overwhelming support. Grassroots activist intensity from both parties made the issue impossible for insiders to combat. With the consensus forming on the right, and newly elected Senator Elizabeth Warren providing high-profile advocacy against Too Big to Fail on the left, reformers on both sides could be able to muster a groundswell of support. "People are more educated about this, much more than five years ago," said Sherrod Brown. "I just saw the power of the Internet in my own campaign. We can do that again here."
Another major obstacle to the entire effort is a White House that believes they solved this problem with Dodd-Frank. That was the assessment of Treasury Secretary Jack Lew (a former Citigroup executive) in his confirmation hearing in February. Under Tim Geithner, the Treasury Department actively halted Brown-Kaufman (one anonymous Treasury official said it would have passed with their support). Overall, the Too Big to Fail issue ranks low on the administration's priority list, below immigration reform, gun safety, and the federal budget. Senator Brown has not yet held direct discussions with the White House on his legislation, and only a few with Treasury. "You need more leadership from the administration to make this happen," said Sheila Bair. "We didn't have much on Dodd-Frank."
Reformers of both parties agree that Dodd-Frank does not go far enough to deliver the changes needed to end Too Big to Fail and create a safer banking system, especially since only around a third of the rules under the law have even been implemented (banks successfully delayed many rules and gutted others as they worked through the labyrinthine rule-making process). "There has to be a broader attack," said Sherrod Brown.
Regardless of the outcome, the bipartisan movement to end Too Big to Fail has already paid dividends. Regulators who deal with mega-banks every day, who are typically quiet and cautious in their public pronouncements, have begun to identify the problem and challenge the industry. This directly results from the positive feedback loop generated by the reformers, believes Simon Johnson, former chief economist for the IMF. "The political atmosphere matters," he said. "Regulators are watching the political debate, and an insistent effort gives them great support to do the right thing." It also helps to have an issue where some conservatives actually want to get to a solution instead of reflexively blocking anything that deviates from the status quo. Because they view taking down big banks as a proxy for taking down Big Government, they favor government action to achieve the goal. And that creates opportunities for strange bedfellows and bottom-up alliances.
Even if the current legislative effort ends in failure, it could assemble evidence and refine solutions to be used when the mega-banks generate another crisis. "Ultimately this is an 'End of Days' plan, something you can take off the shelf for next time," says Neil Barofsky. Nobody wants to wait that long, and if both parties continue to work together, maybe they won't have to.
