Barack Obama defeated Mitt Romney by a large enough margin—three percentage points and more than three million votes—that it’s hard to say changing any one thing about the failed Republican presidential campaign would have made a material difference. But a call to break up America’s biggest banks might have been as good a suggestion as any. In one bold, Nixon-to-China move, Romney could have gone a long way toward shielding himself against attacks that successfully branded him a vulture capitalist and Wall Street plutocrat. Indeed, such a policy position would have allowed Romney to paint Obama as the status-quo, crony-capitalist defender of liberal and libertine Wall Street—the inside-Washington politician whose big financial-reform law, known as Dodd-Frank, moved all the pieces but left the mega-banks still far too big for government to let them fail. Romney would have been exactly the Mr. Fix-It, pro-market populist his campaign wanted voters to believe he was.
It is true that advocating such a position in the summer or fall of 2012 would have required a complete flip-flop on the issue. In March, I interviewed Romney and asked whether Washington should heed the advice of, among others, Dallas Federal Reserve Bank president Richard Fisher and do what I’ve just described. Romney quickly dismissed the idea. “I’m not looking to break apart financial institutions,” he said. “I think what caused the last collapse was a convergence, almost akin to a perfect storm, of many elements in our economy and regulatory structure. And if we have in place modern regulation and regulators who are keeping their eye on the ball, there’s no reason to think we will go into another crisis of the kind we just endured as a result of the mortgage meltdown.”
At the time, Romney’s own financial-reform agenda was limited to a single sentence on his campaign website: “Repeal Dodd-Frank and replace with streamlined, modern regulatory framework.” Skimpy, to say the least, but even that was enough to help Romney create one of his best moments in his triumphant first debate against Obama when he called Dodd-Frank “the biggest kiss that’s been given to New York banks I’ve ever seen.” Still, that moment would have been even more powerful had it been backed by bold policy.
As for flip-flopping, Romney certainly did enough of it in his political career to have done it one more time. Little more than a month after his interview with me, Romney was presented with a perfect opportunity to change direction. In early May, the nation’s largest and most reputable bank, JPMorgan Chase, stunned securities analysts and investors by declaring it had lost $2 billion in a complex hedging strategy in just six weeks and stood to lose even more. (The losses have since grown to more than $6 billion.) And at the very moment JPMorgan was offering its mea culpa, Team Obama was gearing up a $200 million campaign to paint Romney as a greedy, tax-dodging corporate raider. But what if Romney had seized on JPMorgan’s trading losses to say he had previously expressed doubt about the wisdom of breaking up or limiting the activities of America’s largest financial institutions—but that the JPMorgan disaster had caused him to revise his thinking. He could then have called for an international accord to devise a break-up strategy.
One top conservative economic thinker brought the idea directly to Romney advisers, who were stunned that there was a burgeoning conservative backlash against big banks that saw these giant institutions as the monstrous progeny of a crony-capitalist union between Washington and Wall Street. Another adviser thought that whatever the policy merits of the idea, it would be too hard to explain to voters, especially the members of the Tea Party, how this historic government intervention in the private sector could be harmonized with Romney’s advocacy of smaller government and deregulation. Instead, Romney continued to try and make populist hay out of bashing China’s currency manipulation.
Throughout all the debates, the primary, and the general election, Romney never really spoke at great length about financial reform or the financial crisis. But one could surmise that given his lifetime in the world of high finance, he perhaps instinctively sees large banks as a necessary part of the modern global financial system. Indeed, he might well view the issue much the same way as his colleague at Bain Capital, Ed Conard, does. In his recent book Unintended Consequences, Conard is highly critical of the notion:
Busting up big banks will only reduce our economy’s competitiveness. A fragmented banking industry may have worked when the economy was highly regionalized, but today the world continues to progress to a more integrated whole, with or without us…. London has already overtaken New York as the world’s center of finance. To strengthen our leadership in the world, we need financial institutions that can successfully serve, lead, finance, and compete in this increasingly integrated and growing market. And these institutions will necessarily be too big and too integrated to fail.
If that thinking does reflect Romney’s, it might help explain his and his campaign’s failure to connect. What America really needs, now more than ever as the anemic recovery continues to limp forward, is a rugged, shock-resistant financial system that efficiently allocates capital to entrepreneurs looking to start new businesses and companies looking to expand an established business. America needs lots of successful banks and capable bankers to run them. What it doesn’t need is 20 banks with combined assets equal to 90 percent of the U.S. economy. It doesn’t need five mega-banks—JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, and Goldman Sachs—with combined assets equal to 60 percent of national output. But America has them nonetheless, and it might be Romney’s belief that they have grown to this size as a result of natural forces and market needs. They haven’t, though.
It’s true that banks in advanced economies have been getting bigger for some time, actually for more than a century. Between 1870 and 1970, according to an analysis by the Bank of England, the average ratio of bank assets to GDP rose to 70 percent from 16 percent, about 6 percentage points per decade. But that process gained momentum in the 1970s thanks to the widespread adoption of financial-liberalization policies, such as the elimination of credit controls and the deregulation of interest rates. Since 1970, according to the Bank of England, the ratio of bank assets to GDP in advanced economies has risen by about 30 percentage points a decade to more than 200 percent.
The financial sector has become not only bigger, but more concentrated, particularly in the United States, where the share of assets held by the top three banks has risen to 40 percent of GDP from 10 percent since 1990. This was not an organic market development. Andrew Haldane of the Bank of England credits the dramatic upward shift to “escalating expectations of state support for the banking system.” He continues to explain: “These expectations generate lower funding costs, in particular for the largest banks, which in turn encourages further expansion and concentration, worsening the too-big-to-fail dilemma.”
In the United States, the predisposition toward bank bailouts might have begun in 1971 when the Federal Deposit Insurance Corporation saved Unity Bank, a black-owned institution in inner-city Boston, out of fear that its failure would “touch off a new round of 1960s-style rioting,” according to former FDIC chairman Irvine Sprague. But the notion that some institutions were “too big to fail” took hold with the 1984 rescue of Continental Illinois, then the nation’s eighth-largest bank, when it became insolvent after purchasing bad energy loans from an Oklahoma bank. After the Continental bailout, the comptroller of the currency told Congress that 11 banks had already become too big to fail. This was followed by a series of direct and indirect government-managed bailouts, including those of the savings and loan industry, hedge fund Long-Term Capital Management, Bear Stearns, Fannie Mae and Freddie Mac, AIG, and numerous banks through the application of funds from the TARP program in 2008.
Add excessive size to a system that favors bailouts, and you have created what Haldane calls a “self-perpetuating doom loop.” The industry is so large and concentrated and complex that the failure of any institution could create financial instability, and so major players receive an implicit government guarantee of their debt. The incentive, then, is to become even bigger and more complicated, raising the risk of financial crisis and further taxpayer bailouts. America cannot afford another major financial crisis right now and probably not for decades to come. In 2007, publicly held federal debt as a share of national economic output was 36 percent. In 2012, it will be roughly double that level. And once you add in what Uncle Sam owes in social-insurance entitlements, total U.S. debt is bigger than the entire economy. That amount of indebtedness is well past the 90 percent level identified by economists Carmen Reinhart and Kenneth Rogoff as a serious drag on long-term growth.
So how to break the doom loop and eliminate the “too big to fail” phenomenon? One possible way is by giving governments clear and pre-planned “resolution authority” to liquidate a failed, systemically important financial institution. This is the Dodd-Frank approach. But it assumes a heroic breed of policymaker who will, in the middle of financial turmoil, resist the temptation to bail out bondholders even though it would cause less economic disruption in the near term and clip taxpayers in the long term. As Haldane points out, “The history of big-bank failure is a history of the state blinking before private creditors.” Despite its stated intentions, Dodd-Frank provides all the authority necessary for another mega-bailout.
Although one of its key provisions prohibits the Federal Reserve from using its funds to bail out individual financial firms, as it did in rescuing AIG, there’s more to the story. Peter Wallison, my colleague at the American Enterprise Institute, points out that the law permits a new Financial Stability Oversight Council to “designate any financial institution that is engaged in clearing, settlement or payments activities—that is, almost every bank of any size—as eligible for a Federal Reserve bailout if its financial condition might prevent it from performing these functions.” That’s a doom-loop loophole, and one already understood as such by investors who continue to assume politically connected mega-banks are still backstopped by Uncle Sam. Which they are, given that their funding costs continue to be lower than they are at smaller banks.
Another approach is to raise the cost of being big and complex by making banks hold a lot more capital or by taxing them based on their riskier activities, or both. In so doing, they would internalize the costs of business decisions. With costs higher on certain activities, the theory goes, banks would likely reduce or even divest themselves of activities that are no longer as profitable. Both options have some merit, but they do not offer a complete answer. Current levels of complexity at the largest institutions and the diversity of their activities make it hard to devise appropriate risk fees or capital levels. In both cases, regulators are trying to figure out just the right price to put on risk. Before the financial crisis, the variety of banks’ assets was such that regulators had to rely on the internal risk models of the banks themselves when setting capital requirements. In addition, banks are always innovating and their activities are always evolving. They’re always one step ahead of the regulators. Thus, says former Kansas City Fed president and current FDIC director Thomas Hoenig: “It is impossible to always charge the right fee on a continuous basis, [and so] some firms will still end up taking too much risk. While the likelihood of a crisis would be reduced, the cost of a crisis may still be too large.”
Or…you could break up the banks. Some ideas for doing so focus on size. Dodd-Frank prohibits mergers of financial companies if the new company would hold more than 10 percent of the nation’s deposit market share. But the law does not prohibit organic growth, nor does it prevent banks from rising to an enormous scale relative to the size of the economy. There is considerable disagreement over “how big is too big,” which is why Fisher of the Dallas Fed favors an international agreement that would break up these institutions into more manageable sizes. For his part, Hoenig prefers to focus on what banks do rather than how big they get. He proposes allowing banks to engage in traditional activities that are based on long-term customer relationships, such as commercial banking, underwriting securities, and asset management. Banks would be barred from broker-dealer activities, making markets in derivatives or securities, trading securities or derivatives for their own accounts or for customers, and sponsoring hedge funds or private-equity funds. “The result would be banks that are smaller, simpler, safer,” he says. “Not only would they be less likely to spark financial crisis because management would know government might let them fail, the cost of failure to taxpayers would be less.”
Opponents offer two major substantive criticisms. One is that large, complex economies need the large, complex banks we currently have. But their existence owes as much to government policy as to market needs. The weight of the evidence suggests that without government subsidy, as the Bank of England study found, “there is no longer evidence of economies of scale at bank sizes above $100 billion. If anything, there is now evidence of diseconomies which rise with bank size, consistent with big banks becoming too big to manage.” The other objection is that these institutions are impossible to unravel. The criticism is actually a powerful justification for giving it a try now rather than during a financial crisis. Hoenig also points to the divestitures required by the Glass-Steagall Act in the 1930s and the breakup of the monopoly phone system in the 1980s as examples suggesting a split can be done in orderly fashion.
A diverse, competitive, agile financial system responding to market forces rather than lobbyist desires is both smart politics and smart policy. Too bad for the Romney campaign that its boss and economic advisers never realized that. But as it recovers from the 2012 electoral fiasco, the conservative movement has an opportunity to make a restructured financial system a cornerstone of a new pro-market foundation.