How to regulate “Big Banks”

How is it that the large banks are still profitable and growing after the financial crisis of 2007-08? How were they able to pay off all their federal debt and still manage to post financial gains? According to Simon John and James Kwak, authors of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown the answer is real simple; the system is stacked for large banks. This Washington-Wall Street relationship has allowed banks to receive special rates by the Feds allowing them to benefit from billions of profits instead of turning around and making that money available for borrowers for a significant premium.

In July of 2011, Democrats in Congress passed the Dodd-Frank reform bill that will impose limits on how big banks can actually grow. They put in place regulation on derivatives and a customer protection that would prevent fraud tactics that some of these big banks like Goldman Sachs is currently getting investigated for. They also plan on closely monitoring these companies to hopefully cut down on the risky, high leveraged transactions.

Kwak and Johnson argue that government regulation needs to find a way to break up the banks that are “Too Big to Fail.” Specifically, they should reform the finance system now, to put in place a modern analog to the banking regulations of the 1930s that protected the financial system for over fifty years. In other words, they should break up the banks that have majority control over our financial systems and are basically holding our economy hostage. Moreover, if there are no banks that are too big to fail, then there will be no unspoken subsidies favoring some banks as opposed to others; creditors will do their part in ensuring that banks do not take too much risk, and banks that do fail will have to be bailed out the tax payers’ expense; ultimately, leveling the playing field, which will make the financial system better able to withstand the next crisis ahead.

According to William R. Gruver, Author of OPM Addition, Another way to handle this situation would be to restrict Wallstreet to private ownership so that the patners who take the risk are held liable for their actions and the risk tolerance will follow accordingly. He mentions in a private partnership, partners faced unlimited personal liability when determining which investment they were going to make. Therefore, a partner is solely liable for all of his actions. When deciding to go public, their attitudes changed because there was limited liability. So if they (the owners) made a bad investment, they would only be liable to pay “partnership” money, not their entire savings account.

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8 Responses to How to regulate “Big Banks”

  1. Jordi says:

    Do you know what the piece of legislation was? Did they mention it by name? The book is recent, but I wonder if it was the Dodd-Frank bill, which did pass. Then I wonder if the final version included what John_son_ and Kwak wanted.

    What do you think of Gruver’s approach versus the legislative approach the 13 Bankers authors advocate?

    PS- if that is pronounced “quack,” well, poor guy.

  2. Jordi says:

    Thanks for doing that! A follow up post could be whether what is _actually_ in Dodd-Frank is what Johnson and Kwak thought would help.

    In fact, this could even be the kernel of your final paper if you are very jazzed about it.

    Meanwhile, Dodd-Frank and banking regulation in general continues to be a political football. I heard Newt Gingrich, Republican candidate, on the radio today saying he thinks they should immediately repeal Dodd-Frank.

  3. Alyssa Haglund says:

    While William R. Gruver’s idea that all wall street banks should be privately owned would force them to take more responsibility and have a direct tie to their investments, I don’t think that it would help to resolve the Too Big to Fail situation. Many of these large institutions were already large and continuously growing before becoming public. Before going public in 1999, Goldman Sachs was criticized for not disclosing financials and participating in risky business because nobody actually knew what Goldman did. This type of skepticism is likely to come back across the board if the wall street banks are forced to be privately owned.

  4. mcardinute says:

    The idea Gruver is trying to depict is eliminating the risky techniques that partners are doing with peoples money. When they have to invest their own savings and child’s college fund, they will be more conservative and satisfied with the marginal gains because like you said they are completely liable for their investment decisions. I don’t think it will solve the T.B.T.F. situation by itself, but personally I feel its one aspect that could alter the mentality of partners risk taking strategies knowing they have their personal savings on the line not mine or yours. And as we know, one of the huge problems today is the fact that these big banks want to partake in highly-leveraged, risky transactions (with other people’s money), so how would this attempted change in partners mentality, not be some what beneficial to the overall economy?

  5. jte004 says:

    I would agree that banks that are too big to fail take risky transactions because the people running the company only have to risk what they have invested in the company and not what the company is risking as an entire corporation. This idea is unsettling, especially with the economic times that we live in right now, but what is the best solution? Is the best solution to make moves to break up big banks and change things in a very uncertain economic enviroment. I agree that banks that are too bit to fail need to be broken up, but when is the best time to make this move? Understanding that we some what understand what is going on with the economy currently, what would breaking up the eight or nine largest financial companies do to the economy now? Would this be a case of jumping out of the frying pan and into the fire?

    • Jordi says:

      Good point. But why not now? We are past the “oh crap” moments of 2007-2009. The largest banks (it is six, not 8-9) are choking the political process through their soft power. Their unwillingness to deal with the toxic assets (most of which are tied to mortgages, and hence the housing crisis) they still hold makes them risk-averse because they are not as sound as they seem. The best people at these institutions, the ones who can productively add to the financial sector and ultimately to prosperity, are employable. Maybe some will move into other sectors. That may be personally tumultuous for them, but ultimately good for all of us as we shift to less employment in those parts of finance that are “useless financial activity” and more in the real economy.

  6. mmilne23 says:

    I agree that there is an issue with the reliance of the entire economic system on too big to fail banks. The financial meltdown in 2008 was directly influenced by these banks. However, I might have a cynical look at the world, but don’t you think that because our economy is so reliant on these companies it will be very hard to implement any of the ideas mentioned in the articles mentioned above? Either way by splitting up the banks or converting them to private ownership companies and customers of the companies will lose money. It’s sort of a catch 22 because people want things to change, but how much change are people willing to make when money is on the line?

  7. joshua says:

    Here my solution it correlates with this article… we need some chemo therapy for these large pieces of cancers aka the bank… they are beginning to metastasize spreading nothing but grief to the economy and other uncorrelated markets are getting direct effect of this disease … another option is to let break them down and if they do need a loan give them a high interest rate so it will discourage them from wanting govt bail out money…

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