Eighteen Republican senators recently introduced a bill to repeal the Dodd-Frank financial “reform” legislation. I whole-heartedly support repeal, but repealing Dodd-Frank without delivering a serious alternative would be both a political and a policy mistake of the first order.
The U.S. banking system collapsed in the early 1930s when millions of depositors panicked and withdrew their funds from thousands of banks, forcing President Franklin D. Roosevelt to declare a bank holiday to buy time to calm the public. When the dust settled, one-third of the nation’s 30,000 banks had failed.
Congress and the Roosevelt administration enacted comprehensive and coherent reforms to ensure that history would not repeat itself. The reforms brought nearly 50 years of stability to the U.S. financial system. While remnants of those reforms remain in place, so much has been dismantled that today’s regulatory regime is fatally flawed.
The most significant and controversial reform in the 1930s was creation of the Federal Deposit Insurance Corporation (FDIC). The Roosevelt administration opposed deposit insurance fearing that it would force strong banks to subsidize weak banks, create a moral hazard and ultimately, place an enormous burden on taxpayers.
An intricate compromise was reached. The deposit insurance limit would be set at a modest $2,500 (equivalent to $41,000 in today’s dollars) designed to protect small, unsophisticated depositors.
Competition in financial services would be tightly controlled to significantly lower the risks and the potential for conflicts of interest. The rates of interest banks and thrifts could pay for deposits would be regulated. Entry into the business would be made more difficult, and branch banking would be curtailed. Investment banking would be separated from commercial banking, and banks would be separated from nonfinancial firms.
Almost unimaginable leaps forward in data processing and communications technologies, combined with intense lobbying by larger financial firms, made it very difficult to maintain the legislated barriers to competition. The final straw was the battle against inflation in the late 1970s and 1980s which drove interest rates above 21 percent, decimated the economy and ultimately, resulted in the failure of 3,000 U.S. banks and thrifts.
Restrictions on deposit interest rates had to be removed immediately as banks and thrifts were hemorrhaging deposits to newly created money market funds and other instruments that were able to pay higher rates of interest. Barriers to interstate banking were the next to go, as regulators looked for more potential purchasers for troubled banks and thrifts.
Permissible activities of banks and thrifts were broadened in the hope that they might become more profitable. One of the last vestiges of the 1930s reforms was eliminated with the 1999 repeal of the Glass-Steagall Act, which had separated commercial banking and investment banking.
At the same time we were dismantling barriers against competition in financial services we were expanding deposit insurance coverage and creating “too big to fail” financial institutions. The deposit insurance limit in the United States now stands at $250,000 (more than six times the inflation-adjusted original limit).
Worse yet, we allow money brokers and other intermediaries to package and place deposits in a manner that expands FDIC coverage to almost unlimited amounts. Moreover, the five largest financial institutions now control more than 50 percent of the U.S. banking system and cannot be allowed to fail, so they have de facto unlimited taxpayer backing.
The worst nightmares of the Roosevelt administration have come to life. We have created a financial system in which the strong and prudent subsidize the weak and reckless. We have privatized profits and socialized losses.
The FDIC published a book in 1984 commemorating its 50th anniversary. It warned that deregulating the banking industry without finding ways to strengthen significantly supervision of banks and to impose greater private-sector discipline was a “prescription for disaster.”
It has been over a quarter of a century since the FDIC issued this clarion call. In the meantime, U.S. taxpayers spent $150 billion in the early 1990s to clean up the savings and loan mess and forked over some $700 billion for the Troubled Asset Relief Program (TARP) program in 2008.
We are in an intolerable situation that will only get worse the longer it goes untended. The signal failure of the Dodd-Frank financial “reform” legislation it that it does almost nothing to change the status quo.
We need to start over on financial reform and get it right this time. Any serious bill will strengthen considerably financial institution regulation and will find ways to impose increased discipline on the marketplace.