Breaking up (the banks) is hard to do

In the context of the 2016 presidential election, it’s easy to forget that Congress recently passed the most sweeping financial reform in modern history. Nearly a decade after the financial crisis, whether or not Washington has done enough to make sure reckless behavior on Wall Street is kept in check remains a major divide among Democrats.

Republicans, for their part, criticize Wall Street too—and also, often even more vociferously, the Obama Administration’s approach to financial reform and the economy. The Dodd-Frank Act is subject to regular criticism from Republican presidential candidates and other national political leaders, largely on the grounds that it excessively burdens businesses and financial institutions, and thus acts as a drag on job creation and the broader economy.

Most of the potential for additional financial reform comes from the Democrats—but we need to go back in time a few years to explain how today’s situation came to be.

Out of the ashes of the financial crisis rose an outspoken Oklahoma-born Harvard professor, initially picked by Congress to oversee the Treasury Department’s management of the Troubled Asset Relief Program (more commonly referred to as the Wall Street bailout). That professor soon became a U.S. Senator (and progressive darling): Elizabeth Warren. Sen. Warren, outraged over Wall Street’s reckless behavior, the influence of special interests in Washington, and the growing economic challenges of middle class families, unleashed a broad wave of liberal anger and activism trained on the financial industry. This “Warren Wing” of the Democratic party was a home for progressives who felt President Obama’s policies weren’t sufficiently bold, or that he was too quick to compromise. And, with Warren as their voice in the U.S. Senate, the “Warren Wing” became a powerful voting bloc—often pressuring the Obama Administration and other Democrats to take more aggressive action on a range of economic issues.

It was no surprise that a broad movement to encourage Elizabeth Warren to run for President emerged well before the first primary ballots were cast. Sen. Warren made clear she had no plans to run for the highest office, while former Secretary of State Hillary Clinton likely kept her fingers crossed that she meant it. Sen. Warren stayed in the Senate, and the movement gradually ebbed, lacking a high-profile leader to run for the presidency—or so it seemed.

Few anticipated that Bernie Sanders, a largely-overlooked 73-year old Independent Senator from Vermont, would reactivate the “Warren Wing” during the Democratic primaries—although a closer look would have revealed that his messages, policy positions, and record were closely aligned with Sen. Warren. With a core message focused on overturning the power of the “billionaire class,” Sen. Sanders made more aggressive Wall Street reform a central part of his platform, and he regularly attempts to use this position to draw distinctions between himself and Secretary Clinton.

Secretary Clinton, for her part, had no role in the Obama Administration’s response to the financial crisis, since in her role as Secretary of State she focused on international affairs. Complicating perceptions of her, however, is the fact that the financial industry benefited from certain deregulations—some of which helped set the stage for the crash—that were enacted during President Bill Clinton’s time in office. This deregulatory push was promoted by officials who remained close advisers to Secretary Clinton in the intervening years, and some of whom had strong ties to Wall Street financial firms that had been bailed out during the crisis, Goldman Sachs top among them.

With an unexpected surge in support of Bernie Sanders from a broad section of the Democratic Party, Wall Street reform has emerged as a major issue in the Democratic primary. Although it’s unlikely that further financial reforms will pass Congress unless Democrats retake the House and Senate, the policy platforms of Sanders and Clinton are broadly representative of the approaches of the “Warren Wing” and more establishment Democrats, respectively. There are three areas of focus:

Breaking up the banks. Senator Sanders is an advocate for breaking up the largest financial institutions immediately. Secretary Clinton says she will also break them up, if it becomes clear that doing so is a necessary step for ensuring a more stable financial system.

Of all the major actions that could be taken to supplement the Dodd-Frank Act, breaking up the largest financial firms is one with the likeliest odds of coming to pass—although still highly unlikely. Here’s what breaking up the banks entails, and why it could happen.

Breaking up the banks could happen in two ways. First, Congress could pass a law that puts size limits on financial institutions, which would require firms that exceed that size to shrink and break up into separate entities. One way to do this is to limit the amount of debt that a single financial institution could take on relative to the entire productive economy. For example, Sen. Sherrod Brown (D-OH) has introduced legislation that would prevent any bank from having non-deposit liabilities valued at greater than 2 percent of U.S. GDP, and any investment bank from having non-deposit liabilities exceeding 3 percent of GDP. This would only affect the six largest megabanks—JPMorgan, Wells Fargo, Citigroup, Bank of America, Goldman Sachs, and Morgan Stanley. These institutions would be given three years to comply by drawing up their own proposals to meet this goal.

The other way that banks could be forcibly downsized is if financial regulators decide to demand it. In fact, the Dodd-Frank Act requires regulators to break up the largest institutions if they cannot develop a credible plan—called a “living will”—that would show how they would resolve themselves in a bankruptcy situation so that their failure wouldn’t pose a systemic risk to the broader financial system. Regulators recently reviewed the megabanks’ living wills, giving 5 of them—JPMorgan, Bank of America, Wells Fargo, Bank of New York Mellon, and State Street Corp—a failing grade. These institutions have until October to resubmit their plans, but if they are unable to earn a passing grade, regulators have the authority to lay out broad parameters on their size or activities and let the institutions determine the best way to reorganize under the new requirements.

Talk of breaking up the banks in this way has been on the rise, coming not only from liberal Democrats, but also from some prominent Republicans, senior Federal Reserve officials, and even some on Wall Street. Reasons vary, with some in the industry making the case that the largest institutions are simply too large and complex to manage competently. Others point out that the largest institutions are even bigger than they were before the crisis, causing the financial industry to be more consolidated than at any time in modern history.

Most recently, Minneapolis Fed Governor Neel Kashkari took an unexpected and aggressive stance toward breaking up the largest banks, by putting the issue at the center of a year-long research effort to develop ways to address potential risks to the global economy—which promises to keep the issue in the news for a long time to come.

Reinstating the Glass-Steagall Act. Another difference between Sen. Sanders and Secretary Clinton is their position on the Glass-Steagall Act. The Glass-Steagall Act was a law passed in the aftermath of the Great Depression that sought to separate commercial banking activities— managing customers’ deposits—from investment banking activities that could jeopardize customers’ savings. That law was repealed under President Clinton in 1999, less than 10 years before the financial crisis hit, with many large commercial and investment banks merging in the intervening years. We explain more about the Glass-Steagall Act and its role in bringing on the financial crisis in this post.

While Sen. Sanders supports separating commercial and investment banking through a new law like the Glass-Steagall Act, Secretary Clinton has not called for its reinstatement, while the financial industry is in near-universal opposition to bringing back the law. In fact, Secretary Clinton has said reinstating Glass-Steagall wouldn’t go far enough to fix the financial system, which is why she outlines a different approach.

Regulating the “shadow banking” sector. Secretary Clinton focuses her plans for Wall Street reform not on breaking up the banks or reinstating Glass-Steagall, but on developing additional regulations to ensure that the “shadow banking” sector doesn’t put the financial system or broader economy at risk. Earlier this year, Secretary Clinton released a detailed plan outlining where she believes additional reforms in this area are needed.

The shadow banking sector refers to non-bank financial institutions that fall outside of the purview of federal regulators: large insurance companies, hedge funds, mortgage lenders, and similar types of non-bank institutions. The Dodd-Frank Act included measures to bring some oversight to these sorts of firms, including giving regulators the authority to “designate” certain large non-bank firms for additional oversight (see our post here) and creating the CFPB to regulate a broad range of consumer-focused financial firms.

It’s impossible to say whether any of these changes will ever come to pass, but with public anger toward Wall Street still white-hot nearly a decade after the financial crisis, these issues aren’t likely to fade from the political debate for some years yet.