Our economy is not working for most Americans. Despite low unemployment rates, we are still suffering from the effects of the 2008 financial collapse, which is going to cost the U.S. more than $20 trillion. Just one remarkable statistic from a Federal Reserve study released in September 2018 highlights how bad things remain for most Americans ten years after the crash: The bottom 90 percent of people in the U.S. are economically worse off today than they were in 2007 by between 17 percent and 35 percent.
The crash resulted from the massive deregulation of the financial sector by large bipartisan majorities through the presidencies of Bill Clinton and George W. Bush. The result was numerous too-big-to-fail financial giants that were also too leveraged, too interconnected, and too complex.
The response to the collapse was to re-regulate those financial conglomerates in the comprehensive 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. Passing this law was virtually a miracle given the enormous amount of money and might the financial industry put into killing it. Now, however, the Trump administration is helping the industry do just that.
While it is hard to remember now, Trump was the most anti–Wall Street presidential candidate since FDR in the 1930s. He attacked Wall Street relentlessly, directly, and explicitly throughout the campaign and attacked his opponent, Hillary Clinton, nonstop for being in the pocket of Wall Street. He even put the then-CEO of Goldman Sachs, Lloyd Blankfein, in his last campaign ad as one of the biggest threats to the people of the United States. As the Center for Public Integrity put it, Trump “made Wall Street excess one of the boogeymen of his campaign.”
Obviously, President Trump never met Candidate Trump, because President Trump has merged the White House with Wall Street and adopted big finance’s priorities as this administration’s top priorities.
The critics of financial reform have claimed that the law and rules would kill banks’ revenue and profits, which would prevent them from lending and would in turn kill economic growth and jobs. In fact, in virtually every quarter since 2009, including throughout 2018 and the first quarter of 2019, the biggest banks have recorded or eclipsed record revenues, profits, and bonuses while at the same time increasing lending. In fact, America’s banks made $237 billion in profits in just the 12 months of 2018, with the six biggest raking in more than $120 billion of that. As one noted commentator observed, “American banks are minting money.” U.S. bank profits as a percentage of GDP is now higher than it has ever been and trending up. And JPMorgan Chase just recorded the “highest ever quarterly profit for a U.S. bank.” Not surprisingly, this has resulted in banker pay skyrocketing, including “JPMorgan CEO Dimon’s Compensation Topp[ing] Pre-Crisis Record.”
The U.S. is now in the second-longest economic recovery in history, and the biggest banks are enjoying the fruits of that more than anyone else. Additionally, the biggest U.S. banks have not been hurt by the rules in global competition, as they continue to dominate the globe in almost all banking and finance categories.
Like most significant legislation, Dodd-Frank was not self-executing. Multiple regulatory agencies had to adopt hundreds of rules to turn the law into a reality. Each agency had to consider, propose, finalize, implement, interpret, and ultimately enforce each of those hundreds of rules.
By the time the Obama administration left office, over 300 rules had been finalized, according to one count. Even so, at least 115 Dodd-Frank rules remained to be completed when the Obama administration ended, including executive compensation rules, securities-based swap rules, credit rating agency reform, and commodity speculation rules.
Since taking office, the Trump administration has set about dismantling the core pillars of financial reform by:
· lowering capital requirements;
· weakening stress testing and living wills;
· allowing more proprietary trading;
· enabling more unregulated derivatives dealing;
· rolling back consumer and investor protections;
· reducing prudential regulation of systemically significant banks;
· neutering the regulation of systemically significant nonbanks and the shadow banking system;
· defunding research and monitoring of the financial industry; and
· stopping enforcing the laws, if not actually siding with the predators.
While all are important, the deregulation of systemically significant nonbanks is worth singling out, because it illustrates the Trump administration’s sheer recklessness. This will recreate the two-tier regulatory system that incentivizes and rewards regulatory arbitrage and a bailout culture. The implications for financial stability are immense.
ONE OF THE most important reforms of Dodd-Frank was the creation of the Financial Stability Oversight Council. All the key federal and state financial regulators are members of the FSOC, and it is chaired by the Secretary of the Treasury. Its mission is to identify and make sure known and emerging risks that threaten the financial stability of the United States are properly regulated.
Importantly, the FSOC is not merely focused on preventing the last crash. Its decidedly forward-looking task is to think about possible future threats to prevent the next crash. The FSOC is also the only organization in the U.S. with the authority, mandate, and duty to regulate the shadow banking system, which, as is well known, was at the core of causing and spreading the 2008 crash.
The key mechanism for the FSOC to achieve that is by designating systemically significant nonbanks, which would then be subjected to heightened regulation. Such a nonbank could only be designated as systemically significant after an extensive, thorough, and data-driven analysis that then obtained a supermajority two-thirds vote of the FSOC’s ten voting members.
It is important to remember that innumerable nonbanking institutions received trillions of dollars in bailouts in 2008-2009, which by definition meant that they were systemically significant. Nevertheless, the Obama administration was very cautious in using the designation authority and designated only four systemically significant nonbanks for increased regulation.
Two were and should have been entirely noncontroversial. One was AIG, which not only failed spectacularly and engaged in outlandishly irresponsible conduct, but also required an unlimited bailout, which ultimately amounted to $182 billion. The other was General Electric (GE), which, although with fewer headlines and less egregiousness, would have gone bankrupt without being bailed out as well.
The Obama administration de-designated one of the four—GE—after it altered its operations to reduce risk and was no longer viewed as systemically significant. Thus, when the Obama administration left office, there were only three nonbank financial institutions in the U.S. designated as systemically significant.
However, just months after the new administration took office, President Trump’s appointees to the FSOC voted in September 2017 to de-designate and deregulate AIG: “Nine years after it received an $182 billion taxpayer bailout, federal regulators said … that AIG is no longer ‘too big to fail’ and released the global insurance giant from stricter federal oversight,” as The Washington Post put it. Led by Treasury Secretary Steven Mnuchin in his capacity as head of the FSOC, this action concretely transformed Trump administration deregulation rhetoric into reality.
AIG’s de-designation left just two nonbanks in the entire U.S. that were identified as systemically significant, and Trump’s deregulators went to work on de-designating them. The first was MetLife, which had sued the FSOC during the Obama administration seeking a court order to be de-designated. The FSOC lost in the district court in a tendentious opinion with a dubious basis, but the Obama administration appealed. That case was pending when the Trump administration took over. It dismissed the appeal, which effectively de-designated MetLife, leaving the deeply flawed district court opinion as the law.
That left just the Prudential Financial insurance company as the only nonbank designated as systemically significant. While it was no surprise, it was nonetheless “a stunning reversal” for Trump’s FSOC to de-designate Prudential in October 2018.
As an article in American Banker put it, “Goodbye, nonbank SIFIs. We hardly knew you,” or, as Bloomberg put it, “Once Feared on Wall Street, Dodd-Frank’s Watchdog Is in Retreat.”
Today, according to the Trump administration, there is not one single nonbank financial company in the entire U.S. that is systemically significant. Of course, that’s ridiculous. Does anyone honestly think that if there was another crash today that the many gigantic nonbank financial institutions wouldn’t be lined up for bailouts just as they were in 2008-2009?
Worse, these actions are re-creating the two-tiered regulatory system that existed before the last crash that enabled massive risks to build up in the shadow banking system. Those risks were unregulated and unseen until it was too late.
Before the crash, banks were regulated by four separate regulatory agencies. However, nonbank financial firms engaging in high-risk, bank-like activities were lightly regulated, if they were regulated at all. Unsurprisingly, bank-like activities and their associated risks then migrated from the higher-cost, regulated banking system to the lower-cost, unregulated shadow banking system, which is where much of the 2008 crash was spawned.
Making systemically significant banks and nonbanks subject to a similar regulatory regime was intended to end the misaligned incentives and opportunities for regulatory arbitrage as heightened regulation forces those entities to internalize the costs of their high-risk behavior.
As the chairman of the Federal Reserve during the crises, Ben Bernanke, explained, AIG maximized regulatory arbitrage opportunities at the expense of the stability of financial markets: “AIG exploited a huge gap in the regulatory system. There was no oversight of [AIG’s] Financial Products division. This was a hedge fund, basically, that was attached to a large and stable insurance company.”
And since AIG did not reserve or post margin for the credit default swaps it sold, it was probably the most highly leveraged nonbank in the world at the time as well as the most interconnected.
A quick glance at the global counterparties paid by AIG after it was saved from bankruptcy and bailed out shows how incredibly interconnected AIG was throughout the world. More than half were non-U.S. and many U.S. counterparties were pass-throughs to non-U.S. parties.
The egregious and reckless behavior of AIG provided the foundation for bipartisan and industry-wide support in 2009-2010 for creating an entity that would eliminate the regulatory gaps.
The FSOC was the answer to the regulatory arbitrage problem; that’s how it became the governmental entity with the power and duty to analyze and designate for regulation systemically significant nonbanks.
The FSOC’s deregulation of AIG will once again leave it unsupervised. In fact, it will now be less regulated than it was before the 2008 crash. As soon as it was de-designated, AIG went on an acquisition spree. As Bloomberg News reported, “AIG Is No Longer Too Big to Fail, So Now It Wants to Get Bigger,” which the Financial Times pointed out, “would be a reversal for AIG, which since the crisis has shed assets around the world … in a push to become smaller and simpler.”
That, of course, was the basis Trump’s FSOC used to justify de-designating AIG, which immediately changed course.
One well-known commentator captured how this action will incentivize a bailout culture that will lead to a bailout cycle:
[G]iven AIG’s centrality to the last crisis—and its plans to start growing again—it does seem a little ominous. What if the entire cycle plays out [again]? Regulations were loosened [in the years before the 2008 crash], AIG grew big and reckless, it crashed the economy [in 2008], [received massive bailouts,] regulations were tightened , AIG got small and cautious , everyone forgave it, regulations were loosened , and now AIG can grow again. What comes next?
Importantly, that cycle will infect all of Wall Street and finance as it did before. That’s because the message sent to enormous financial firms and their executives is that recklessness and breaking the law are high-return investments. There is little doubt that AIG and other financial firms will repeat their grossly deficient and irresponsible behavior as a result of the perverse incentives created by the bailouts, the lack of accountability resulting from the behavior, the irresistible gains generated for executives, and the lowering of regulatory requirements again.
Unfortunately, Trump’s FSOC is now trying to make sure its deregulatory practices continue long after it is gone. The FSOC recently proposed a baseless and irresponsible rule that would inhibit if not entirely prevent the designation and regulation of systemically significant nonbanks like AIG in the future. Not only is this contrary to Dodd-Frank, but it will blind the FSOC to emerging systemic risks and increase the likelihood and severity of the next crash.
WE NEED A financial system once again that supports the productive economy; produces sustained and durable economic growth; protects investors, consumers, and workers; and creates economic security, opportunity, and widespread prosperity. History shows that effectively regulated, the financial system can be the foundation for achieving and sustaining that economy.
After the Great Crash of 1929 and in the midst of the Great Depression of the 1930s, numerous laws and rules were passed and numerous financial regulatory agencies were created. The result was layers of protections between the high-risk, dangerous financial activities on Wall Street and the hardworking families on Main Street. Importantly, those layers of protections were of different types: structural, regulatory, and supervisory.
We had financial stability and no catastrophic crashes for almost 70 years, but it took just seven years after industry propaganda and cash fueled mindless deregulation for it to cause another historic financial crash.
That history is powerful proof that regulation and financial stability are not the enemies of growth and prosperity, but that broad-based deregulation is. That is why Dodd-Frank re-regulated the financial industry and why the Trump administration’s deregulation is so reckless and dangerous.
Strong, robust, and effective markets require strong, robust, and effective rules. The right kind of rules require transparency and accountability, engender investor confidence, and lead to a balanced financial system that fuels the productive economy. We’ve done it before; we did it well; we did it for a long time; and we can do it again.