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U.S. Banks Need To Be Safer For The Sake Of Main Street

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The 2008 financial crisis continues to adversely hurt millions of people in the United States.  Anat Admati, Mehrsa Baradaran, and Jennifer Taub have contributed a significant body of research to design needed changes to the U.S. banking system for the sake of ordinary people.  Together, we brainstormed what the necessary next steps should be to make banking safer for Main Street.

Stanford Business School Professor Anat Admati, author of The Bankers New Clothes, and one of Time Magazine’s 100 Most Influential People in 2014 agrees with the U.S. Financial Inquiry Commission that the 2008 crisis was avoidable, since it was caused by weak corporate governance  and policy failures.  According to Admati, ten years after the crisis “the financial system remains fragile, inefficient and dangerous.” Her concern is that “Despite reforms put in place after the crisis, bankers, politicians and regulators consistently overstate the system’s health and the effectiveness of new rules.”

Admati believes policymakers still lack “the political will to address the underlying flaws in the system.” These problems are due to the failure of markets to produce efficient outcomes when the interests of people with better information and control conflict with the broader public interest. She has focused in particular on trying to ensure that banks use more equity funding, a cause that has support from both sides of the political spectrum.  She is concerned about recent Republican efforts to water down these particular rules for banks in the $100 billion to $250 billion asset range. “In principle, tailoring the rules sounds good, but the challenge is in the implementation.  Tailoring is likely to lead to weakening of the rules in a race to the bottom.” She emphasizes that institutions with assets between $50 billion and $250 billion have been and can again be quite dangerous. The failure of one or more of them, or what will happen to many of them as a result of a change in economic conditions can cause significant disruption and collateral harm. The Savings and Loans crises along with others around the world have shown that even small institutions that all take similar risks and tend to fail at the same time can be dangerous and costly.

Photos are courtesy of Stanford Business School, University of Georgia, and Vermont Law School.

According to Admati, complex and costly regulations can actually mask the fact “that there are regulations that are poorly designed and allow banks to borrow on privileged terms and to remain opaque.” The Federal Reserve has many tools to ensure banks are safer, first and foremost by preventing the large payouts to shareholders that are depleting the equity. “Money paid to shareholders (or managers) is no longer available to pay depositors and other creditors. Share buybacks and dividend payments reduce the banks’ ability to absorb losses without becoming distressed,” stopping to lend or requiring bailouts at taxpayer expense.

Admati observes that “it takes many collaborating individuals, each responding to their own incentives and roles, to enable a dangerous financial system.” To take on the entrenched system, the public must become more aware of the issues and the potential dangers from banks’ subsidized recklessness.  “The obstacles to banking reform are man-made. We need to challenge flawed claims and demand that policymakers create and enforce proper rules.”

University of Georgia legal scholar Mehrsa Baradaran and author of How The Other Half Banks and The Color of Money worked on Wall Street at a law firm during the financial crisis. For her, the crisis was truly revelatory. “My views on financial inclusion and regulation were formed during the financial crisis,” she explained. She realized during the crisis that "the elegant theories of laissez faire and market discipline were moot during a panic. Banks are umbilically connected to government. Letting the entire system fail was not an option. This is because banks operate using other people’s money." She noted that “the Federal Reserve, FDIC, and the entire federal government regulatory infrastructures are necessary both in good times and in bad to stabilize the system. Especially in bad times.”

Baradaran notes that Bank of America CEO Ken Lewis expressed a sentiment that was echoed by both the Bush and Obama administrations, “We are so intertwined with the U.S. that it’s hard to separate what’s good for the United States and what’s good for Bank of America. . . . They’re almost one and the same.” Baradaran found this “to be true and it was very troubling.”  She questions what this level of bank and government interconnection “means to democracy. Can we have a true democracy democratically elected government and have banks as middle men providing credit? People need banks. Yet, banks get to choose their clients. Hence, banks that rely on the federal government for support are leaving out an entire sector of the population because they are too poor to be profitable.” She is concerned that “We have two unequal systems for credit. One is based on the market such as payday lenders, which charge excessively, and the second is banking, supported by the governments. How can we have a system of banks with this much public support who actively exclude and/or exploit a large sector of the population?”

Baradaran recommends that we need to cut out the middle man in certain situations.  She proposes some sort of public option in banking, either through the post office, the Federal Reserve, or some other mechanism that provides direct access to the underbanked. She argues that the Dodd-Frank law did nothing to change the fundamental structure of these large banks and their deleterious incentives. “The Consumer Financial Protection Bureau (CFPB) was a huge win for consumers, but most of the regulatory portions of Dodd Frank was a doubling down on the same risk management and stress testing models that firms were already doing and failed to prevent the crisis. Essentially, nothing has changed since the crisis. We need to creating a safer and more egalitarian banking system. We still have TBTF banks and they're even bigger. We have is a winner take all system of finance.”

In several publications, including a recent piece in American Affairs, Baradaran argues that there are a lot of myths about providing banking services through the post office a model that has worked well in other countries. “We had banking services in the post offices from 1910-1966,” she explains. “The post office gets mail to every corner of the US. We are talking about letting people have small accounts through the post office. The Post office is democratic and has adapted with technology. Postal banking will not fix the banking sector, but it's a small step that could help millions of people have access. Then, we need to think more about fundamental reforms akin to those adopted after the New Deal. We need a vigorous public debate about what banking structure we want as a people. This is not a decision we should leave to bank lobbyists and risk analysts. Ken Lewis was right that we're all in this together. We need to internalize that message and work to shape a banking system that works for all of us.”

Vermont Law School Professor Jennifer Taub and author of Other People’s Houses found similarities between the 1980s savings and loan and the 2008 financial crises. “The lead up to both crises had reckless banks, operating under different names, which failed, while the same regulators overlooked fraud and abuse.”  According to Taub, while the Dodd-Frank Act of 2010 represented a good first step in making our financial system more resilient, “its efficacy was undermined by immediate and relentless industry efforts to dilute and delay its implementation.”

Taub explains that it is high time for Congress to step in where regulators have either left gaps due to inaction or gaps in their authority. She identified opportunities for regulatory action that include “further reducing excessive borrowing by the top six banks as well reducing dependence by banks and other financial firms on overnight and other short-term borrowing and providing transparency concerning securities lending transactions.”

Unfortunately, rather than addressing the deficiencies in Dodd-Frank to strengthen banks, “Congress has headed in the other direction and given a big gift to the banks at the public’s expense. This law, S.2155, will hurt homeowners and allow giant banks once again to take big risks with taxpayer-backed, FDIC-insured customer deposits.”  One of Taub’s biggest concerns is that this law, “referred to pejoratively as the Bank Lobbyist Act, invites predatory lending. It encourages banks with up to $10 billion in assets to once again offer predatory mortgage loans to millions of borrowers.”  This means that the law “will bring us back to the bad days of banks making mortgage loans to homeowners based on their ability to pay just an initial "teaser" rate, not the fully-amortized rate. Practices like this put borrowers at risk of losing their homes if they cannot afford the higher long-term payments.”

According to Taub, this law puts banks at risk when these home loans default. Moreover, it also will remove from 25 of the 38 biggest banks in the United States from Federal Reserve Bank supervision. “This is not the time to take down guardrails. With markets soaring, it is the time to put in place measures to cushion against another downturn.”

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