Victor Juhasz
This story is part of the Prospect’s series on how the next president can make progress without new legislation. Read all of our Day One Agenda articles here.
“When the president signed the financial reform law, that was half-time,” one of Wall Street’s top lobbyists said about the aftermath of the Dodd-Frank Act. “The legislators left the field and now it’s time for the regulators to take over.” That byzantine process of rule-writing and implementation moved at a glacial pace, was captured by industry, and resulted in rules that were riddled with one loophole after another.
As a result, the Trump administration didn’t really need congressional action to realize its deregulatory agenda, though some lawmakers were willing to do Wall Street’s bidding anyway. Witness regulators’ recent gutting of the Volcker Rule, the ban on banks engaging in risky and speculative trading that was one of the few structural reforms contained in Dodd-Frank, a change regulators made on their own.
There are two important lessons from this experience. One is that remaking the financial system does not need new laws. Congress has delegated so much authority over the financial sector to watchdog agencies that experts questioned whether they even needed new legal authority to overhaul the industry after the 2008 financial crisis. The second is that tinkering around the margins is insufficient. A new presidential administration needs to use that authority to go big and change the fundamental structure of Wall Street.
Cutting Down the Big Banks
While the Dodd-Frank Act contained important reforms, it didn’t end the existence of Too Big to Fail banks by breaking them up. It did, however, establish a process that requires banks to draw up a “living will,” proving that they can go bankrupt without triggering a financial crisis. Regulators evaluate these plans, and they have the authority to restructure a bank if the living will doesn’t pass their smell test, by forcing a bank to “divest certain assets or operations,” per Dodd-Frank’s language. This could be a meaningful tool to shrink the size and complexity of the largest banks.
The Federal Reserve also has the unilateral authority under a law called the Bank Holding Company Act to force large banks to divest subsidiaries if they threaten the safety, soundness, or stability of the financial system, a lower standard than the one required by the living will process. The Fed can also order divestitures when it determines that a large bank is not well managed. While the Fed has never used either of these powerful tools, they certainly have a rationale to do so, given ample evidence that the largest banks take outsized risks on a daily basis.
The boldest breakup proposal would impose a size cap on our largest banks. The enforcement action against Wells Fargo in the wake of its fake-account scandal shows that the Fed already has legal authority under the Federal Deposit Insurance Act to cap the growth of any bank that engages in unsafe and unsound behavior or violates any Fed-imposed conditions. While this authority has to be used on a bank-by-bank basis, imposing a cap on the dozen or so most systemic banks wouldn’t be overly burdensome for a large agency with lots of staff and resources. Alternatively, Dodd-Frank allows the Fed to impose any broad-based regulation that it determines is “appropriate” in order to “prevent or mitigate risks to the financial stability of the United States,” potentially including size limits.
Another way to limit the power and reach of the financial supermarkets would be through limits on bank activities. Over decades, the Office of the Comptroller of the Currency, a national bank regulator, used letters and orders to broaden the meaning of “banking” and any “equivalent” activities under the National Bank Act to include increasingly complex financial products. Likewise, under Alan Greenspan, the Federal Reserve interpreted the 1999 Gramm-Leach-Bliley Act expansively to allow banks to trade and own commodities like oil, gas, and electricity and own and operate commercial businesses like shipping, warehouses, and pipelines as “complementary” to financial activity. The broad interpretations of these powers were done unilaterally, so they can also be restricted or reversed in kind.
Separately, the FDIC could use its authority to provide or withhold deposit insurance as leverage to restrict activities that are unsafe or unsound. In this sense, regulators could confine government support to plain-vanilla banking services, encouraging the idea that banks should be boring—taking deposits, lending them out, and then going golfing.
Maybe no activity is more “unsafe and unsound” than the largest U.S. financial institutions’ investments in businesses that are significant drivers of climate change. Over the past three years, the six largest U.S. banks provided over $700 billion in fossil fuel financing. Large banks and asset managers are also making investments in the companies driving deforestation, including in the Amazon rain forest, which is fast approaching a state of crisis.
Climate change poses very real risks to the U.S. financial system, and regulators have various financial authorities at their disposal to force Wall Street to divest from fossil fuel financing, including higher capital charges for financing fossil fuel projects and deforestation, stress tests that account for the true financial risks from climate change, and even portfolio restrictions on financing projects that drive fossil fuels and deforestation. By failing to take meaningful action, U.S. regulators are both neglecting their duty to preserve financial stability and jeopardizing the goal of Green New Deal proponents to achieve net-zero greenhouse gas emissions in the United States.
Tackling the Industry’s Other Bad Actors
Private equity is a predatory business model that enriches a few elites at the expense of workers, retirees, and communities. Investors lose out, too, and they need substantive protections from being fleeced by excessive fees and unimpressive returns. Current policies have been far too modest to really influence the power of these firms. There are bold new proposals being advanced to crack down on private equity looting. While targeting some of the worst abuses, including the asset stripping that private equity engages in as portfolio companies approach bankruptcy, requires legislation, other reforms can be done by regulation.
The IRS could crack down on some types of management fees that private equity uses to strip wealth from portfolio companies, while receiving favorable tax treatment as capital gains. The IRS proposed regulations to treat these fees as ordinary income and tax them at a higher rate, but they have not been finalized and could be strengthened. The SEC can also shut down the egregious tax loophole known as “carried interest,” based on its authority under the Investment Advisers Act of 1940. The law allows the agency to prohibit fund manager compensation derived from the “share of capital gains,” which is how private equity titans unjustly take earnings at a lower tax rate. The SEC and Department of Labor could also prohibit private fund managers from requiring pension plans to waive their fiduciary duties to their investors.
Credit rating agencies were among the banks’ biggest accomplices in the financial crisis, which is impressive given the fierce competition for that title. They nonetheless emerged from the reform process largely unscathed, and there is even some evidence that the bad practices that precipitated the last crisis are returning to the marketplace.
A Dodd-Frank amendment instructed the SEC to restructure rating agencies directly, but the agency ignored the statute and implemented a weak series of paperwork requirements. However, the SEC could return to Dodd-Frank to enact a variety of structural reform options, including breaking up the big-three cartel that controls the market, or exposing them to additional legal liability for faulty ratings. The SEC could also follow the plain language of the Dodd-Frank amendment, and develop a new model for assigning credit-rating jobs to firms, eliminating the conflicts of interest that arise when large securities issuers can use future business flow to influence credit ratings.
The failure to prosecute high-level executives for white-collar crimes has fed calls for more individual accountability. Like many other issues, this is a question of a lack of will rather than legal authority. The Sarbanes-Oxley Act, enacted after the Enron scandal, requires CEOs to attest that their financial filings and internal controls are sufficient. While the SEC has failed to use this provision aggressively to pursue executives responsible for corporate scandals, SOX, as it’s known, could be a powerful tool. The attestation statute includes possible prison time, and meaningful personal liability will make executives more attentive to compliance. When laws are broken, attestation also establishes legal liability that the government can use to pursue white-collar cases that has been lacking. The SEC can also require companies to establish a “performance bond” that locks up executive compensation for a set period of time, making it available so that responsible executives, rather than the company’s shareholders, pay fines and penalties.
Protecting Consumers
A new administration has all the tools it needs to begin to remedy historic and still present discriminatory lending practices, which have perpetuated the racial wealth gap. An economic and racial justice agenda would include re-elevating the Consumer Financial Protection Bureau’s Office of Fair Lending back into the bureau’s enforcement division and conducting a meaningful crackdown on lending discrimination. Bank regulators could also reinvigorate the Community Reinvestment Act as the tool it was meant to be: a way to drive investment into low-income communities of color. And they could revive a Department of Housing and Urban Development rule that requires affirmative remediation of past discrimination, not mere promises not to do it again.
A cartel of three private credit bureaus keeps track of our financial transactions. Their data assists lenders in deciding who can get a loan and on what terms, and even whether people get a job or an apartment. Credit reporting is the industry with the most complaints in the CFPB’s public database, and that combined with the massive Equifax data breach and subsequent botched remediation process tells you all you need to know about how poorly these companies are run. These for-profit companies work for and with lenders, not consumers. This leads to a mess of inaccurate and erroneous information that benefits lenders, which can charge more or use the threat of a negative report to coerce borrowers.
CFPB could fix this distorted system by using its authorities over research, consumer complaints and information, fair lending, and financial literacy to create a public credit bureau. A credit bureau run by a consumer protection agency would have lower costs for consumers and lenders alike, ensure accurate reporting of financial information, only allow access to credit information for limited financial purposes, and provide consumers with services to help them improve their financial awareness.
The government can also put the states to work. For decades, nationally chartered banks have appealed to federal law, and the solicitous agencies enforcing it, to “pre-empt” state attorneys general from investigating or enforcing unfair and predatory banking practices. Wall Street reform sought to tip the balance back in favor of the states, but captured federal regulators ignored the intent of Congress and issued a rule that misinterpreted the law. A new watchdog at the Office of the Comptroller of the Currency could reinterpret the National Bank Act to give states more leeway to hold banks accountable. This would enable strong enforcement of state consumer protection laws, like caps on interest rates for consumer loans.
The Financial System We Need
Key to this financial-reform agenda is the adage that “personnel is policy.” We will never get the financial sector that we need if Trump administration regulators are allowed to keep their jobs. The CFPB’s Kathy Kraninger and the FDIC’s Jelena McWilliams both have terms leading their agencies until 2023, and in Kraninger’s case, it would take negligence or malfeasance in order for her to be removed.
An incoming administration must have a plan for enacting its agenda, even if Republicans hold a majority in the Senate to frustrate presidential nominations, or if Trump appointees continue to serve in the executive branch. That means learning from conservatives’ creative arguments around removal powers, for example, by citing a CFPB director’s use of her consumer protection agency’s power to help the absolute worst actors in the financial marketplace as grounds for firing. It also means strategic and aggressive use of the Vacancies Act, the federal law that governs vacancies in important positions.
None of this will be easy. Senator Dick Durbin (D-IL) once said that the banking industry is “the most powerful lobby on Capitol Hill. And they frankly own the place.” In the modern administrative state, agency lobbying is intense. One study of the Volcker Rule’s original interagency rulemaking process found that 93 percent of agency contacts during the sample period came from industry trade associations or companies. If all else fails, industry can always sue to challenge any new reforms, and there’s no telling how many of the cases will end up in the hands of the extreme and unqualified judges that President Trump and Senator Mitch McConnell have packed into the federal courts.
A new administration should welcome these fights. Each loss clarifies which side our representatives are on, and each victory would put us on a path toward a more just and equitable financial system.
Candidate Spotlight
The financial industry has been absent in the 2020 Democratic primary. In 2016, Hillary Clinton and Bernie Sanders released detailed financial-reform plans, and fought over them repeatedly in primary debates. Through the first three debates of 2020, there has not been a single question about the financial industry. The stakes are certainly higher today, since the Trump administration has consistently deregulated the sector, setting up the conditions for another crash.
All that said, there is a divide on this issue. Bringing back anti–housing segregation rules and potentially closing the carried interest loophole represent low-hanging fruit. BETO O'ROURKE endorsed a public credit reporting bureau in his small-business plan. Those with a greater understanding of Wall Street’s role in our economic lives go much further. BERNIE SANDERS has endorsed enforcing rules reducing the size and risk of large banking institutions, reforming the credit rating agencies, holding CEOs accountable under Sarbanes-Oxley, and building a public credit registry. ELIZABETH WARREN endorsed all of the above as well, though she hedged a bit on the credit registry, saying, “A public option in this space is worth considering.” Warren has pushed banking regulators to use many of these tools over the years, including the FDIC’s living will authority and IRS crackdowns on carried interest.
