Senator Bernie Sanders has built a national campaign on the idea that we have to “reign in the banks.”  I like Bernie’s sincerity, but what most of his followers probably don’t know is that even before the Dodd-Frank reform, the banking industry was already the most regulated industry in the United States.  But the question of regulation is not “grade by weight.” The question is whether the regulation hits the target.  I don’t think it does in the case of Dodd-Frank–although I admit that the equity capitalization of banks has improved somewhat over the past several years.

I want to try a thought experiment.  I want to try to imagine a world in which there is no banking regulation and ask myself what the core of such regulation ought to be.

The reason I want to go through this exercise is that the more complex regulation gets, the more it favors big businesses over small businesses.  Because of that, the more regulations we heap on to the banks, the worse our “too big to fail” problem becomes.

I’m not making that up.  Smaller, regional banks are struggling and the increasing consolidation of banks has been going on for many years.  In 2000, there was an almost even split between the total US banking assets held by the five largest banks versus the small banks; in 2013, the spread between the two had widened to about 28 percent.  I don’t think that big is necessarily bad per se, but it can be if the proper controls are not in place.

Now, before I go through this exercise, please understand that I am not advocating total deregulation.  The S&L crisis that followed the S&L deregulation done by the Reagan Administration should not be forgotten.

As a young lawyer, I worked on Resolution Trust Corporation (RTC) deals.  Good for me and the law firm; bad for the taxpayers whose real estate assets got sold in what was equivalent to a fire sale (albeit a necessary evil).  Any fool should be able to understand that the banking business–which holds people’s savings and then turns around and lends that money out to others–is not the same case as a flower shop or a restaurant.

Banking, taken together with corporate finance, is the lifeblood of our economy.  As the song in “Cabaret” says:  money makes the world go round.  We can’t have a totally free market in banking, but maybe we can streamline some of the regulations.

Two key events in the banking timeline were the enactment of the Glass-Steagall Act in 1933 and its repeal and replacement by the Gramm-Leach-Bliley Act of 1999.  Glass-Steagall was part of series of reforms including the regulation of securities that came about as a result of the stock market crash of 1929 and the crushing depression that followed.

The core idea behind Glass-Steagall was to create a firewall between the banking, securities (corporate finance), and insurance industries because they were rightly seen as having very different risk profiles.  Senator Phil Gramm, a free marketer economist, had the idea that the walls of Glass-Steagall should come tumbling down so that our finance firms could get big enough to compete on the international stage.  President Bill Clinton went along.

In other words, our current “too big to fail” problem is something that we did intentionally to ourselves.  But the erosion of the Glass-Steagall firewall was a factor, albeit not the only factor, in the financial crisis of 2008.  The Dodd-Frank reform of 2010 was a reaction to that crisis that did not completely, or even substantially, solve the problem.

Many will not remember, but Judge Richard Posner, who was famous for his economics-based legal opinions, wrote a book in which he warned that we should wait a while to properly determine the precise causes of the crisis before we tried to fix it.  No one listened to him.  Strike while the iron is hot.  Don’t let a good crisis go to waste.  Run around like a chicken with your head cut off.  Enter Senator Barney Frank and the teachings of the Harvard Law School.  Have you seen the videotape of Frank before the 2008 crisis saying “I want to take on more risk”?

So, back to my thought experiment.  What are the basic elements needed in banking regulation?

First, because we do fractional reserve lending where only a fraction of the total bank deposits must be held in reserve while the rest is loaned out, we must have a guideline for the minimum amount of the reserves.

Second, because we are asking people to put their money in a bank that does fractional reserve lending, we need some kind of deposit insurance like the kind we get from the FDIC.  Without that, many folks wouldn’t risk putting a lot of money in a bank.

Third, because some money will be held by the bank in an investment portfolio, we must have some guidelines around that portfolio.

Sidebar:  did you know that prior to the 2008 financial crisis, some banks had 40% or 50% of their investment portfolio in mortgage backed securities?  In effect, the banks were originating loans, selling them to the secondary market where it was repackaged into more “diversified” pools with structured tranches to add credit support, and then buying those mortgage backed securities for their own portfolios.

Obviously, this defies the basic investment rule about diversification:  you know, not having all your eggs in one basket?  Why don’t we have a limit on the percentage of a banks’ investment portfolio that can be in any one asset class?  Or why don’t we require any increase in an asset class above a particular percentage to be authorized by the CEO and board of directors?  Could it be that it would unduly restrict the demand side of the market for mortgage loans, thereby harming the banks financially?  Hmmmm.

Fourth, you need regulations to foster bank credibility, which means honesty and full disclosure in dealing with depositors and borrowers.

Fifth, you need to restrict the types of things that a bank will loan money on.  For example, one practice that was targeted in the early days was stopping banks from loaning money to people to buy stocks, which is a bad practice that accelerated the bubble that led to the stock market crash of 1929.

This is a tricky area because bank lending decisions determine the fortunes of businesses and individual households and therefore the entire economy.  It is better to let bankers call these shots or should government have a say?  We could debate that until the cows come home, but the outcome of that debate obviously matters a lot.

Sixth, you have to have some guidelines around the selling of various financial products to customers. Those products differ in risk and complexity and many people do not understand them, yet tend to be somewhat trusting of bank officials.

Seventh, while I don’t like price controls, you probably need some concept that says that at a certain point an interest rate becomes usurious and illegal.  Admittedly, we do have be careful with that.

Eighth, because most banks are corporations funded by equity and debt, we need to pay some mind to the question of how thin their equity capitalization is and how leveraged they are.

Ninth, we need some variant of the Glass-Steagall idea that the difference in risk between commercial banking, securities (corporate finance), and insurance means that the risk of one line of business should not be allowed to unduly affect the other.  It’s bad enough when one area collapses.  If they infect each other and they all collapse, then we will be eating bugs for dinner.

Just because the essence of bank regulation is simple doesn’t mean that we can do the whole thing with fifty pages of regulation.  For example, in insurance regulation the insurers must file financial statements. That requirement is simple enough, but to standardize the reporting requires a book-length set of detailed instructions.  That doesn’t obviate my basic point that we can simplify things if we go back to the fundamentals and then think forward, however. It just means that we can’t be overly simplistic about the implementation of the more general policies.

A word about the Federal Reserve.  When a government can print money freely, you are using what we call a system of “fiat” money.  When you have a fiat money system, you need a central bank to control the money supply because the relationship between the money supply and the quantity of goods and services produced in an economy has an effect on the inflation rate.

So we can’t just get rid of the Federal Reserve altogether.  Nor does the idea of bringing it further under governmental control help because the Fed is politicized enough as it is.

By the way, are you aware that the Fed is not the government?  Private bankers are in control, although it is quasi-governmental in a way that is too complex to explain here.  Back under President Jimmy Carter, the Congress changed the charter of the Fed to expand its jurisdiction beyond inflation to include worrying about unemployment.  Some academics now want to go even further and expand the Fed’s jurisdiction to all of the national gross domestic product or NGDP.

The question is this: to the extent we think that the Fed is a “bad driver,” why would we want to expand its power?  That said, we are being too hard on Federal Reserve Chair Janet Yellen, who is pushing on a string with her low interest rate policy.  If we did more on fiscal and regulatory reform we could really help out, instead of putting it all on her shoulders.

A couple of ancillary points worth making.  First, banking is global and there are a variety of nonbank finance mechanisms, so we cannot regulate in a vacuum.

Second, central banks’ pursuit of a low or zero interest rate policy makes it difficult for banks to make money on loans and creates a disincentive for people to put money in banks, thereby restricting the total amount available for bank financing. This helps the big corporations who are financed by capital markets in equity (stock) and debt, but again, it makes life harder for small business and individuals who need to borrow from commercial banks.  It also creates an incentive for banks to make money charging high fees for various routine services, which in turn creates an incentive for government regulate those fees.

In addition, it would be easy to educate high school students about finance, but I personally think that the finance industry wants customers who are sheep. Unfortunately, that works until it doesn’t.  There are dangers in having a population that is financially illiterate, including, but not limited to the danger that one of those ignoramuses becomes a member of the U.S. Congress or even the President of the United States.

Then there is the issue of media. Have you ever wondered why there so little reporting on Fannie Mae, Ginnie Mae or Freddie Mac?  It’s scary, but I suspect that it has something to do with the immense size of their real estate portfolios, their intermixing with government, and their raw power.

Moreover, while I don’t support the wholesale lynching of bad bankers, certain individuals engage in behavior that is sufficiently sociopathic to warrant a personal criminal or civil lawsuit and not merely a fine on the corporate entity.

In the wake of the 2008 financial crisis one of the ideas I suggested to the Treasury Department was that banks originating mortgage loans should hold those loans for a few years before being allowed to securitize them, in order to create the right incentives around the underwriting of the risk.  They didn’t listen, although I did get a nice thank you letter back for my fresh ideas.

I have worked on Wall Street and I know several bankers in my local community in Honolulu.  Some of them were my classmates in high school.  They are not vampires with long fangs dripping with blood who devour infants for dinner.  They are people like you and me who are responding to incentives.

So please don’t demonize your fellow citizens.  Let’s just get the rules right and the incentives in line with our strategic objectives.

It is easy to think that there is a grand conspiracy going on, and maybe there is, one could make that case.  But I tend to think that many of these so-called conspiracies are really just examples of stupidity and a lack of communication and coordination.  In our reform of business regulations, we must bear in mind that most people can’t handle excessive complexity. A country that grows compliance and lawyer jobs at the expense of manufacturing useful things to sell is a country that is slowly slitting its own throat.


The author works for the State of Hawaii as an insurance regulator, but his views as expressed here do not necessarily reflect the views of his employer. He has a B.A. from Columbia University, a J.D. from UCLA, an M.B.A. from the University of Hawaii at Manoa, and a CPCU.

“Social engineering has failed, but I think that we can continue to improve incrementally through the free exchange of ideas and a relatively free market system.  As we do this, however, we must remain realistic.  We may not have to accept the world as it is, but we must take it as we find it.  You can’t get to utopia by living in a dream world.”  From page 164 of “No More Stupidtry: Insights for the Modern World,” by Lloyd Lim (Tate Publishing 2016).