Break Up the Banks

As the battle over financial reform takes shape, it's become clear there are essentially three camps. The first, represented by the American Bankers Association, which convened in Chicago for its annual conference in October, is the do-nothing camp. Oh sure, ABA's Ed Yingling will say he favors reform and offer warm platitudes to that effect. But if they had their druthers, bankers wouldn't change a thing. Why would they? They now capture all the gains from the risks they take and shoulder few of the costs.

The second camp, which includes the White House and Federal Reserve chair Ben Bernanke, more or less accepts the financial landscape as it is, dominated by a handful of mega-banks like Goldman Sachs, Citigroup and Bank of America, and seeks to contain volcanic disruptions like those that brought about the crisis. The proposals on offer from the White House and Barney Frank's House Financial Services Committee would limit risk through stronger capital requirements, give the Fed the ability to facilitate the bankruptcy of large firms, regulate and standardize exotic securities, and create a much-needed new Consumer Financial Protection Agency to root out predatory and deceptive practices.

The third camp argues that while these measures are worthy, they're not enough. The heart of our predicament is the Too Big to Fail (TBTF) problem. Banks have grown so large that they can't go down without threatening the whole system. Reforming the financial sector thus means breaking up TBTF conglomerates and reinstating the Glass-Steagall Act, with its firewall between investment and commercial banking.

The media have labeled the break-up-the-banks camp as the most "liberal" or "left" option, the bankers' position as the most conservative (also the one the GOP in Congress will courageously defend) and the White House position as the sensible, Goldilocks compromise.

But while critics of reinstating Glass-Steagall dismiss it as wildly impractical, it is supported by a roster of people who hardly count as liberals: John Reed, former head of Citigroup; Mervyn King, governor of the Bank of England; and, most notably and vocally, Paul Volcker, ex-Fed chair and current chair of the President's Economic Recovery Advisory Board.

This isn't surprising, since the insight at the core of Volcker et al.'s proposal comes from the conservative Chicago School of economics. It was, after all, Milton Friedman's colleague George Stigler who developed the theory of "regulatory capture" to describe the ways regulators are subverted or co-opted by the industries they oversee. Given the likelihood that, over time, new regulations will be subject to these forces, it makes sense to supplement regulatory reforms with legal limits on the size and scope (and thus potential damage) of the firms in question. "The banks are there to serve the public," Volcker told the New York Times recently. "And that is what they should concentrate on. These other activities create conflicts of interest."

The results of these "conflicts of interest" were apparent in the streets of Chicago, where victims of the subprime swindle and subsequent financial crisis joined thousands of protesters to make sure the bankers assembled there got to see up close just how much havoc they had wrought and how much anger there is in its wake. The key question, as Congress begins to craft reforms, is whether that anger can be organized and brought to bear on the legislative process. Otherwise, all the Paul Volckers in the world won't matter.

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