As the Democratic presidential primary heats up, one of the major issues has been which candidate has the better approach towards regulating Wall Street. While financial regulation can get into many complex areas, there are some basic points that people should know.
First, financial regulation always leaves enormous room for discretion. Some regulatory agencies, like the Office of the Comptroller of the Currency, are notoriously lax, not because they lack the authority to control the banks and other financial institutions, but because their leadership is content to let the banks do what they want.
Sometimes an agency's character changes with its leader. The Commodity Futures Trading Commission became a serious regulatory agency under Gary Gensler, who headed it in the first six years of the Obama administration. (Gensler is now the chief financial officer of Secretary Clinton's campaign.)
This is a crucial point, since the effectiveness of any regulation will always depend on the political will to enforce it. Even with the deregulatory steps of the 1990s, the Federal Reserve Board still had all the power it needed to rein in the housing bubble. The Fed had authority to regulate mortgage issuance. It chose to ignore this authority during the run-up of the bubble.
The Fed also had enormous ability to influence financial markets through its public statements and research. It could have warned of the housing bubble and used its extensive research department to document the case, as the current chair Janet Yellen did two summers ago in reference to bubbles in several sectors. Instead, Alan Greenspan encouraged people to buy adjustable rate mortgages at the peak of the subprime frenzy.
This point about discretion is important, because whatever words we have on paper, we have to ask whether the people responsible for enforcement will actually carry through. Do we think that Hillary Clinton or Bernie Sanders will appoint people who will break up large banks that pose a risk to the economy? Do we think that they will throw their top executives in jail if they break the law?
The second point is that we should not get caught up fighting the last war. Much of the discussion of regulatory reform programs centers on whether they would have stopped the housing bubble and prevented the resulting financial crisis. While that is an interesting question to ask, this cannot be sole measure of effective regulation.
One of the few areas where I have absolute certainty is that the next crisis, whenever it occurs, will not look like the last crisis. We have to ask whether the regulatory structure that we have in place is doing an effective job ensuring that the financial sector is serving the rest of the economy, not just whether it would have prevented the 2008 meltdown.
In this respect, it is difficult to be very positive about the direction we are currently going. The Dodd-Frank reforms were useful in many areas, most importantly in creating the Consumer Financial Protection Bureau and ensuring that the bulk of derivative trades now occur on exchanges or through clearinghouses, but it is difficult to be very positive about the general direction of the financial industry.
The big banks are bigger than ever. As a result of mergers coming in the crisis, the six biggest banks now have more than $10 trillion in assets, an amount equal to 60 percent of GDP. If people expected Dodd-Frank to end the problem of too-big-to-fail, they have reason to be disappointed. It is difficult to believe that the government would allow J.P. Morgan or Goldman Sachs to go under today, just as they did not allow them to go bankrupt in the crisis.
Some analysts have pointed to a study by the Government Accountability Office showing that the borrowing cost discount enjoyed by too big to fail banks has largely disappeared in recent years. This same study also shows these banks enjoyed almost no too big to fail discount in 2006. Since we clearly had a de facto too big to fail policy in place in 2006, the results from this study cannot be taken as strong evidence for the end of too big to fail.
We are also losing the battle to downsize the industry. There has been research in recent years from both the Bank of International Settlements and International Monetary Fund showing that a large financial sector is a drag on growth. In spite of the crisis and the effects of Dodd-Frank, the financial sector continues to grow as a share of the economy. It was under 17.0 percent of national income in 2007, last year it was almost 18.0 percent. In this respect, it is worth noting that Sanders' proposal for a financial transactions tax would be a big step towards downsizing the industry by eliminating tens of billions of dollars spent each year on short-term trading.
Finally, there is the question of whether people who break the law in the financial industry have reason to fear the consequences. In the years since Dodd-Frank the financial sector has not stopped its shenanigans. There was the famous London Whale incident in which billions of dollars of trading losses at Morgan Stanley were concealed from regulators.
There was also the case of MF Global, a commodity trading company, which apparently used money in its clients' accounts to cover its own trading losses. MF Global was headed by Jon Corzine, a former Democratic governor and senator from New Jersey. No one went to jail, no one was prosecuted.
And, earlier this month Goldman Sachs announced a settlement in which it paid $5 billion related to its mortgage practices during the bubble years. No one went to jail, there were no prosecutions. There was not even an admission of guilt.
In assessing the regulatory agendas of the presidential candidates, we have to ask, do we think they would end too big to fail banks? Do we think they would downsize the industry? And finally, will Wall Street criminals have to worry about going to jail? Those are the big questions facing primary voters.