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Scaling Back Our Bloated Financial Sector

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It's been apparent for several weeks that the Wall Street reform bill will not cut down the largest U.S. banking behemoths to a safe and manageable size. But individual oversized banks are not the only problem Big Finance poses to the economy -- the overall sector is much too large, and if we do not shrink it, we'll be dealing with difficult economic conditions for years to come.

Right before the banking system crashed, the financial sector accounted for an astonishing 40 percent of corporate profits. That share of the economy plunged as banks sought their bailouts, but by the end of 2009, finance was back, again accounting for almost 36 percent of corporate profits.

When the financial industry takes up that much of the economy, it becomes a big problem for two reasons. First, instead of serving as a catalyst for broader economic growth, finance is simply devouring other sectors of the economy. Like money, finance is not a goal in and of itself -- it's just a way to support goods and services that make life better. At 40 percent of profits, finance is not supporting that activity, it's destroying it.

Second, for finance to take up 35 to 40 percent of the total profit pie, it has to be engaging in a lot of raw speculative gambling, rather than economically productive lending. That creates a tower of speculation that can easily topple with a single event -- and the resulting mess can be very hard to clean up. As Nomi Prins has detailed, between 2002 and 2008, only about $1.4 trillion in subprime mortgages were issued, while about $14 trillion in securitized bets were derived from these mortgages. When the subprime market cratered, all that speculation made a big problem much bigger.

So in addition to cutting the biggest banks down to size, we also need to scale back the entire financial sector. There are a handful of provisions in Wall Street reform packages approved by the House and Senate that would help accomplish that goal. Unfortunately, the bank lobby, and in some cases, the Obama administration itself, is fighting those provisions. Here they are:

1. Capital and Leverage

Banks amplify their bets in the capital markets by using leverage -- borrowing a lot of money. If you buy $10 million worth of stock, and it goes up 10 percent, you make a ten percent return -- $1 million. But if you borrow $490 million, put up $10 million of your own money, and put all of it into the same stock, a 10% gain in the stock price scores you $50 million -- a 500% return (it would actually be a little less, as you'd have to pay interest on that $490 million loan, but you get the idea). But if the stock drops just 2 percent, you lose all of your own money, and find yourself $490 million in debt. You are ruined.

Rep. Jackie Speier, D-Calif., managed to squeeze an amendment capping bank leverage at 15-to-1 into the House reform bill, meaning that banks could not borrow more than $15 for ever $1 they put up. That's good -- less leverage means less overall financial activity. Sen. Susan Collins, R-Maine, managed to get a weaker, but related provision into the Senate bill, which would force megabanks to reduce their leverage.

Unfortunately, the Treasury Department and the Federal Reserve are fighting both amendments. Even worse, as Mike Konczal notes, the Treasury is also fighting hard against international agreements to limit bank leverage.

2. Derivatives spin-offs

Five big banks control over 96% of the derivatives market, which totals literally hundreds of trillions of dollars. One of the reasons this market is so big is that banks fund these operations with deposits. Since the government guarantees bank deposits against losses, this funding is cheaper than anything else the bank can get outside of the Federal Reserve, which also lends to all five of those banks. Sen. Blanche Lincoln, D-Ark., pushed a provision through the Senate which would bar any commercial bank that deals derivatives from receiving Fed loans. In practice, this would force the banks to move their derivatives dealing operations into a separately capitalized subsidiary.

The banks, Treasury and the Fed are all fighting this provision tooth-and-nail because it would significantly alter the way the derivatives business is funded. Instead of being able to rely on cheap government money, banks would have to finance their derivatives operations in the more expensive capital markets. When something gets more expensive, people do it less, so the Lincoln plan (authored by Sen. Maria Cantwell, D-Wash.) would trim back the derivatives casino.

3. Consumer Financial Protection Agency

One way banks eat up the broader economy is by simply stealing from consumers. Just about everyone has had a bad experience with a credit card, mortgage or overdraft rip-off. These are, first and foremost, bad for our pocketbooks. But what is bad for our pocketbooks is bad for other businesses--it means we have less to spend on goods and services. So by screwing consumers, banks are really sticking it to the broader economy.

The existing bank regulators at the Federal Reserve and the Office of the Comptroller of the Currency simply have not enforced consumer protection rules over the past decade. Their primary goal is ensuring bank profitability, so if banks profit from consumer abuses, they don't really care. We can end this system of abuse by establishing a strong, independent Consumer Financial Protection Agency (CFPA) tasked only with looking out for consumers. The House language on the CFPA gives the agency more independence and broader authority to both write and enforce regulations than the Senate version, but it also exempts abusive auto dealers from the agency's jurisdiction, which the Senate version does not do.

So what else in the bill will cut back on our oversized finance system? Not much. There is a very weak version of the Volcker Rule, which bans banks from gambling with taxpayer money, but it will take years to implement and can easily be gutted by regulators. That leaves a handful of key provisions that should be focus of the reform fight next year:

1. A financial transactions tax.

Many of our current economic woes are tied to excess speculation in finance. By imposing a tiny tax on trades of stocks, bonds and derivatives, the government can discourage rank speculation while bringing in a lot of revenue for the federal coffers. A tax of just a few tenths of one percent will not seriously effect long-term investors. But for speculators who place big bets on the movement of stocks over the course of an hour, or for flash traders who buy and sell millions of shares in less than a second, this kind of tax actually would matter. Based on trading volumes from 1997, which are vastly lower than today's trading volumes, economist Dean Baker estimates that this tax could bring in $100 million a year in tax revenues, even if the overall trading volume fell by 25 percent.

2. Glass-Steagall

Banks don't just use taxpayer-guaranteed deposits to back their derivatives bets, they also fund all kinds of risky securities businesses with deposits. In the 1930s, Congress passed the Glass-Steagall Act, which barred banks that accept deposits and make loans from operating in the securities markets. By separating taxpayer guarantees from risky activity, the move made that risky activity less profitable, and by extension, less profuse.

3. Regulate Hedge Funds and Private Equity

The current bill doesn't really do anything to rein in these shadowy entities. They'll now have to register with the SEC . . . just like Bernie Madoff.