One of the central disagreements in the still ongoing, though all but wrapped up, Democratic presidential primary is what to do about the big banks.
Bernie Sanders says break ’em up. He argues smaller banks will equal fewer financial crisises. Hillary Clinton, on the other hand, says it’s not so much the “bigness” of the banks that caused the financial crisis, but their interconnectedness and overall riskiness that was the problem.
But while it appears Clinton will survive the populist assault Sanders launched against her campaign, it remains to be seen whether she’ll be as successful fighting large banks and the next financial crisis if she is able to take the White House this fall.
On Monday, Minneapolis Fed president Neel Kashkari, who has emerged as an unlikely torch bearer for the too big to fail crowd, held the second in a series of symposiums on bank bailouts. The focus of one of the panels: Clinton’s plan to rein in the big banks.
Unlike Sanders, Clinton’s plan focuses not on the banks’ size, but how risky the banks are in terms of the amount and types of leverage they take onto their balance sheet. Her thesis: It’s the amount of debt the banks take on that makes them risky, not their absolute size. Clinton has proposed putting in place a tax that banks would have to pay based on how much leverage they take on. As debt goes up, the annual tax would go up, creating a disincentive to take on more and more debt.
At the Federal Reserve Bank of Minneapolis on Monday, economist John Cochrane argued that we need a financial regulatory system that moves away from trying to micromanage countless bank activities to one that simply requires that bank shareholders are willing and able to absorb whatever losses the bank creates.
As it stands now, large banks fund themselves mostly with debt. That’s cheaper, than say issuing shares, because of various government subsidies, from insuring customer deposits to the deductibility of debt for corporate income tax purposes. Cochrane argues that we should simply require that banks fund themselves with much higher levels of equity, i.e. Stock, even suggesting that we could theoretically ban debt financing altogether, though he said we wouldn’t have to go that far in order to prevent another crisis.
This is essentially what Clinton is suggesting with her plan to impose a “risk fee” on complex financial institutions. She has proposed “a graduated risk fee on the liabilities of banks with more than $50 billion in assets,” which would apply to roughly the 30 biggest U.S. Banks. The fee would be higher for banks “with greater amounts of debt and riskier, short-term forms of debt.”
In theory, such a plan would discourage banks from being risky, even if it doesn’t prevent them from being large.
For Sanders supporters, though, such an approach is both overly complicated and too easy on banks. Sanders himself often conflates his desire to prevent another financial crisis with his belief that large corporations in general and banks in particular are simply too powerful as a result of their size. So while cutting down the size of large banks might not be a surefire way to prevent a systemic bank run like what we saw in 2008, it would help his goal of making those individual banks less powerful.
But another appeal of the Sanders approach is that it is both easy for people to understand and simple to implement. You just choose a size—economist Simon Johnson has suggested 2% of GDP—and say that no bank can grow larger. Clinton’s approach requires regulators to decide what kind of debt is risky and to stay on top of banks to make sure they don’t violate the spirit of the regulation. For instance, Thomas Philippon, professor of finance at NYU’s Stern School of Business, argued at the symposium that taxing leverage makes sense, but is easier said than done. He argues that banks could hide their leverage using complex financial instruments like contingent assets or derivatives, avoiding Clinton’s tax while still bulking up on risk.
The symposium underscored the essential difference between Clinton and Sanders during this 2016 election. Clinton has proposed solutions like her bank leverage fee that don’t fit nicely into campaign slogans but are more targeted to to the problems the are supposed to address. Sanders has proposed solutions—like a hard cap on the size of banks—that are easier to promote, but risk being too blunt in its attempt to solve the problem it’s supposed to address.
Both approaches actually have a pretty high chance of failure.
As Phillipon pointed out, banks are pretty darn good at hiding their true riskiness from investors and regulators, so there’s reason to believe that banks will be able to keep on being risky even if Clinton can get her risk fee passed. On the other hand, there’s reason to believe the financial industry as a whole can be pretty risky too even if no individual bank is “too big too fail.”
In other words, the debate between Clinton and Sanders can be seen as an argument over whether it’s riskier to do too much or too little when trying to defend against a threat as grave as a financial crisis. Clinton appears to have won the battle in favor of cautious pragmatism, but with populist feelings running hot even on the Republican side of the aisle, the war over how to regulate the financial industry is far from over.
