As long as housing prices kept going up, this whole process could continue. For consumers, this was a disaster. For the financial system, it was a time bomb. It never dawned on either lenders or regulators that housing prices kept going up mainly because underwriting standards were getting looser. By the spring of 2007, subprime mortgage credit losses were soaring and the securitization market froze. In this macabre game of musical chairs, whoever was left holding the loans was dead. Among the biggest holders were large banks and brokerage firms.
And their regulators had been oblivious to the coming disaster. Before the crisis, bank regulators had two jobs: regulating the safety and soundness of the banks and protecting the consumer. They did a horrendous job on both. One of the most important aspects of the Dodd-Frank financial reform act of 2010 was the division of labor. Today, the Federal Reserve regulates safety and soundness and the new Consumer Financial Protection Bureau looks after consumers dealing with all financial institutions. This is a significant improvement.
Under the new regulatory regime, the leverage of the large banks has been reduced. While Citigroup’s leverage peaked at 33 to one, today it stands at less than 10 to one. The Federal Reserve has forced similar reductions in leverage across the board. Risky proprietary trading desks have been eliminated at banks by the Volcker Rule, part of Dodd-Frank. And while the consumer protection board has been around for only a few years, it seems to have made progress in safeguarding consumers from the more egregious practices of the financial-services industry.
This new system is not perfect. The problem of derivatives — they can increase risk, rather than reduce it, as they were designed to do — has not been completely solved. The so-called living wills (plans the banks must file with regulators in case they run into serious trouble and have to be dismantled) are not complete. And the regulators will have to deal with some of the consequences of the Volcker Rule, such as reduced liquidity in the buying and selling of bonds and other parts of the fixed income market. Yet it is simply a fact that the United States financial system is much less risky than it was before. That does not mean that losses cannot occur, but United States banks are in much better shape to withstand them.
It’s no longer accurate to say that the large banks pose a systemic danger to the American economy. Some argue that they should be broken up solely because they are too politically powerful. Perhaps so, although that power hasn’t managed to prevent regulators from dismantling bank leverage and risk. Furthermore, no advocate of a breakup has come forward with a plan on how to do it. Large banks are global, complex, integrated institutions. Breaking them apart would be incredibly difficult, long and disruptive, and the banks might have to freeze loan growth during the process, slowing our economy even further.
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