Six Years After Lehman’s Bankruptcy, Wall Street Is as Reckless as Ever

Six Years After Lehman’s Bankruptcy, Wall Street Is as Reckless as Ever

REUTERS/Joshua Lott

In his primetime address on Wednesday, President Obama bookended the two mid-September anniversaries that define this era — 13 years since 9/11 and 6 years since the fall of Lehman Brothers, signifying the financial crisis. The debate over how to best fight terrorism and how to best prevent future Wall Street collapses share a common thread, at least according to critics: Policymakers have mostly tried to look busy for the purposes of public image, rather than addressing the root causes of the events.

I’ll leave the foreign policy debate to those better equipped to discuss it, but let’s take financial reform. Though Congress passed Dodd-Frank in 2010, and regulators have written rules ever since (only completing about 55 percent of them more than four years later), the massively complex law has failed to fully contain Wall Street’s predilection for threatening the economy.

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The biggest banks remain too big to competently manage their affairs and too interconnected to be safely dissolved in the event of collapse, as the recent rejection of their “living wills” showed. Wall Street continues to amass outsized risk. Sales of securitized loans based on corporate debt are at a post-crisis high, and protections for investors for these loans have completely broken down.  A recent academic study of the Volcker rule, the signature Dodd-Frank provision to eliminate proprietary trading at deposit-taking banks, found that affected banks have taken on more risk and carried less liquid assets than before the rule’s enactment.

Financial Times columnist Martin Wolf lays the problem at the feet of Dodd-Frank itself, a sprawling document that employs 30,000 pages of rules to merely preserve the existing system. “If we want everything to stay the same, everything must change,” Wolf writes, quoting a character from the Italian epic The Leopard.

If you focus only on one area where regulators have taken significant steps of late, you could actually manage a cheer. Bolstered by a rough consensus that transcends party ideology, and a persistent intellectual force from outside the Beltway, regulators have appeared to agree that if they cannot eliminate financial risk they can at least make it more likely that banks, not taxpayers, will pay to clean up the aftermath.

On Tuesday, Federal Reserve Governor Daniel Tarullo, the central bank’s point person on financial regulation, announced at a Senate Banking Committee hearing what he called a “risk-based capital surcharge” for the most important banks. In reality banks aren’t being charged anything: The requirement would simply force them to use more of their own assets to fund operations, and absorb any losses incurred. 

During the crisis, banks borrowed as much as $98 for every $100 they lent out, meaning that just a tiny amount of losses would make them insolvent. If banks fund their activities with more debt, they can extract more profit from their deals. But this constant grab for funding not only risks individual catastrophe, it tightly couples banks together, as they all borrow from one another. It magnifies a crisis when lending evaporates; as we saw in 2008, even stable financial firms couldn’t find funding and teetered on collapse. Additional capital requirements would add resiliency amid the chaos.

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An international process called Basel III modestly increased capital requirements, but Tarullo has led efforts to consistently hike the baseline for U.S. banks beyond those international benchmarks. In April, the Federal Reserve increased the raw ratio of equity to debt, regardless of the type of assets, to 5 percent, nearly double the Basel III standard. Another new rule forces banks to have enough funds on hand to maintain operations for 30 days. The new “capital surcharge” would increase the ratio on risk-adjusted assets to as high as 9.5 percent. And regulators told the Senate they would take further action if the banks fail to credibly demonstrate how they can be dismantled through the bankruptcy process.

Tarullo stressed that, in determining the proper capital ratio, the Fed would take into account how much short-term wholesale funding a big bank uses. If the bank borrows more money that must be paid back overnight or in a few hours, it would need to retain more capital, in case those funding sources dry up. Tarullo even pointed out that, in reaction to higher capital requirements, riskier financial institutions may opt to downsize themselves. “This measure might also create incentives… to reduce their systemic footprint and risk profile,” he said. 

Each Fed increase on capital has been small and, by some viewpoints, inadequate. And the requirements still rely too much on risk weights, which banks can easily game (and have already begun to, with an assist from allies in Congress). But the trend toward forcing banks to absorb their own losses is unmistakable, and a consequence of focused, persistent, bipartisan demands.

Policymakers and academics on the left and right have highlighted significant increases in capital as the best way to tamp down the risk of taxpayer bailouts. Professors Anat Admati and Martin Hellwig offered the definitive case in their book The Banker’s New Clothes. Martin Wolf, in his new book The Shifts and the Shocks, believes capital can solve a number of problems at once. “It would limit the implicit subsidy to banks… it would reduce the need for such intrusive and complex regulation; and it would lower the likelihood of panics,” he writes.

Senators Sherrod Brown (D-OH) and David Vitter (R-LA) introduced legislation last year to impose higher capital requirements, and though their bill has never received a vote, it has moved the needle in the debate. At Tuesday’s Banking Committee hearing, lawmakers in both parties praised Tarullo’s stance. “There’s a great deal of support in this committee and I think throughout the House and Senate on stronger capital standards like that,” Brown said.

Congress may look feckless, and often is. But a few committed lawmakers, backed by outside support, can effectively get the regulatory apparatus to act. Tarullo has advanced his position on capital steadily. Having Thomas Hoenig, a Republican and perhaps the biggest supporter of higher capital among regulators, in a top position at the Federal Deposit Insurance Corporation has also helped. The Fed has yet to reach the level reformers believe necessary, but its officials have had to listen and react.

Related: People Are Quitting Their Jobs. That’s Good News.

Raising capital requirements will not prevent all of Wall Street’s ills. As recent reports about bankers rigging benchmark rates and prices for credit default swaps shows, America still suffers from a financial crime wave, practically unabated since the financial crisis. “The message for every Wall Street banker is loud and clear,” Senator Elizabeth Warren (D-MA) said this week. “If you break the law, you are not going to jail but you might end up with a much bigger paycheck.”

Considering that the Justice Department doesn’t even do a good job prosecuting themselves, maybe we shouldn’t expect them to prosecute the banks. But if we must live with an out-of-control financial sector — and we shouldn’t — at least we can make progress on having the banks pick up the tab for their own recklessness.

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