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How a Much-Heralded Bank Reform Proposal Could Actually Blow Up the American Economy

The Brown-Vitter bill has excellent features, but it could also increase risks to the financial system.
 
 
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It sounds like a fabulous idea: a bipartisan bill to end big commercial bank bailouts. Though it probably won’t pass, there are certainly many good things in the freshly minted Terminating Bailouts for Taxpayer Fairness Act, co-sponsored by Sherrod Brown (OH-D) and David Vitter (LA-R).

Greater transparency? Like it. Juggernauts like JPMorgan Chase with over $500 billion in assets forced to hold more capital to protect against losses? This is a terrific proposal, the one big idea that would at a stroke make bank bailouts a lot less likely. No more taxpayer funds to bail them out? Three cheers, even if one doubts that federal authorities will ever dare to let another behemoth go down after their ghastly experience with Lehman.

But there’s more to this bailout bill than meets the eye – much more than many progressive cheerleaders realize. Some things in the bill could hurt us, and even increase overall risk in the financial system.

Loud criticisms of Brown-Vitter are coming from predictable sources like corporate law firm DavisPolk. But, as ProPublica’s Jesse Eisinger has pointed out, they aren’t too convincing. Warnings that higher capital requirements could cause credit to dry up, Great Depression-style, as banks scramble to meet them, or the howl that the bill would make U.S. banks less competitive are so much hot air. That’s just the banking industry and its supporters crying wolf again.

So if the banking industry hates the bill, what’s not to love?

The real problem is not what the bailout bill does; it’s what it doesn’t do. Or, more specifically, who and what it leaves out.

If we recall the financial crisis of 2007-'08, the threat of large financial institutions collapsing and causing havoc across the economic system was real and very scary. The U.S. Financial Crisis Inquiry Commission reported in 2011 that risky and reckless activity, coupled with breakdown in governance, had compromised the global economy. Commercial megabanks like Citigroup, Bank of America and JPMorgan (though it doesn’t like to admit it) were over-extended and posed enormous risk.

But there were other financial institutions that were NOT commercial banks that were also extremely dangerous. Remember Lehman Brothers? It was an investment bank, rather than a commercial bank, and it would not be covered under Brown-Vitter. So was Bear Stearns. Does the name AIG ring a bell? Astonishingly, the bill asks nothing new of the giant insurer that we actually did bail out in 2008 to avoid complete meltdown. Giant hedge funds like Long Term Capital Management, which nearly went belly-up in the late 1990s and got a bailout, would also escape the requirements.

It hardly suffices to say, as the bill’s champions do, that the Financial Stability Oversight Council the Dodd-Frank bill established could still intervene if it wants to. That council has been notably slow to move. The plain fact is that holding more capital is desirable not just for big banks, but for all the financial institutions that potentially can bring down the system.

The right question to ask is, why would anyone seek to exclude the non-commercial banks from Brown-Vitter? Well, there’s something going on behind the scenes: Let’s call it Clash of the Financial Titans. Since the financial crisis, the commercial banks have gotten special treatment from the Federal Reserve and the regulators. They know they can be bailed out if they run into trouble. So does everyone else, which gives them a huge advantage over other kinds of financial institutions which do not have the same assurance. The big banks get money cheaper because people know they’ll be backstopped. The big boys also sometimes move risky parts of their business, like derivatives, in and out of the insured deposit sections of their firms, when dubious creditors worry they might go belly-up.