The Coming Bank Bust

This weekend is the one-year anniversary of the bailout. But The Daily Beast's Nomi Prins says the too-big-to-fail banks have only gotten bigger—and much worse could be on its way.

Any 5 year old who plays with Legos or blocks could address the issue of "too big to fail" with more logic than most of Washington. What do you actually do about things that are too big and could fail? Well, if you build too high a Lego tower, it has a greater chance of collapsing. So you divide the tower into smaller parts. Same blocks. Different construction. Less crash risk. Simple.

This reasoning remained lost on Federal Reserve Chairman Ben Bernanke, as he testified before the House Financial Services committee last week. Sure, he took a bit of blame for the Fed’s role in not protecting consumers enough. But despite the seismic failure of the Fed to see or do anything about the financial train wreck as it barreled forward at warp speed, Bernanke concluded that the Fed was “well suited to serve as the consolidated supervisor." (Code for, "Keeping the really big banks from tanking the economy again.")

Bernanke chose to approve the banks for marriage, rather than send them to therapy.

This is the same Fed that didn’t think big banks were big enough going into last fall’s crisis, so decided to make them even bigger. Here J.P. Morgan Chase, you take Bear Stearns and Washington Mutual. Bank of America, you take Merrill Lynch. And Wells Fargo, you take Wachovia. Bernanke chose to approve them for marriage, rather than send them to therapy.

There are several members of Congress skeptical about the notion of leaving the keys to the kingdom with the king who didn’t protect it, notably Ron Paul (R-TX) and Alan Grayson (D-FL), leading the march to adopt HR1207, a bill to audit the Fed. Yet, the Obama administration has backed the Fed for chief big-bank watchdog from the get-go.

What they and Bernanke are really saying is, let’s watch over the really big Lego towers and hope they don’t fall. What they should be saying is—cue 5 year old—let’s divide up the tower into mini-towers, which will reduce the possibility of a fall. Meanwhile, the trillions of dollars in bailout support that the big banks have received this year confirms the notion that whoever is watching, they will be protected from failure—with public money and lots of Fed backing.

Nomi Prins: The Merger That Ruined Ken LewisPaul Volcker, former Fed chairman and one of President Obama’s chief economic advisers, gets the problem with this. A week earlier, he pointed out that this “safety net” approach should, in the future, be restricted to commercial banks—leaving the investment banks, or the speculative divisions within mega-banks, or the AIG derivatives departments of the world on their own. Because as any kid knows, if you reward the bully with extra snacks for disrupting the playground at recess, it’s pretty unlikely he’s going to stop being disruptive. He’ll just get fatter and become more of a bully. Instead, he should be restricted, or even kicked out of the playground for bad behavior.

In the banking arena, removing the safety net for more speculative firms requires breaking up the banks into commercial banks (that deal with consumers’ deposits, savings accounts, and loans), investment banks (that can trade whatever they want—just without public backup when they screw up), and insurance companies (who should stick to their day job of providing insurance, not using insurance policies as capital for credit derivatives trades.)

Effecting these divisions is not as crazy as the banking sector would have you believe. Every year, billions of dollars in merger and acquisition fees are made on the very action of splitting off pieces of companies and moving them somewhere else. We even had legislation that did this in our past. In fact, Volcker evoked the essence of the two words that have never escaped the lips of Obama, Bernanke, or Treasury Secretary Tim Geithner (or for that matter President George W. Bush, or former Treasury Secretary, Hank Paulson): Glass-Steagall.

The Glass-Steagall Act came about in 1933. It changed the rules of the playground. The banking system and its speculative debt-backed practices had trashed the general economy and led to the crash of 1929. Along with Glass-Steagall, President Franklin Roosevelt gave the banks a "time out," or bank holiday, in which they were closed and examined. The FDIC was created to protect consumer deposits in the event of further bank collapses, but it could be effective because it didn’t have to protect losses incurred by ill-suited trading practices.

As intertwined entities, financial firms used deposits and loan payments as collateral with which to accumulate impossible debt, risk, and leverage. Consumer deposits became trading capital. Consumer loan payments became fodder for a $14 trillion global asset-backed securitization pyramid between 2002 and 2007, the toxicity of which brought the world to its knees last year. That the U.S. government did, and still does, condone the current bank landscape and those practices, as evidenced by the trillions in bailout money it has put toward keeping the system’s status quo, is grossly irresponsible.

Breaking up the banks should lie at the crux of the debate in the White House, Congress, and amongst global financial leaders. Reinstating Glass-Steagall, which was repealed in bipartisan euphoria in 1999 (the ceremony for which was emceed by former Treasury Secretary Larry Summers, now Obama's right-hand economic adviser) is the best way to achieve future financial stability. It is the only reform measure that will truly make a difference. As long as commercial banks and investment banks are entangled (and insurance companies, as well), no amount of regulation or oversight will be an absolute deterrent to another financial system meltdown. It will just be damage control.

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These "sweeping financial reforms" of which Obama and Geithner speak simply aren’t. Increasing capital limits, putting derivatives on regulated exchanges (96 percent of which are owned by the largest five banks who will be happy to retain their control), and having a systemic risk regulator deal with the fallout (and there will be more fallout) of institutions that are just too damn big will have limited impact as long as the lines between commercial and investment banks and speculative activities remain absent.

Bernanke, Obama, and Geithner should be thanking Volcker profusely for having the guts, and publicly minded fortitude, to bring up the notion of Glass-Steagall. Indeed, the White House PR team should have gotten Volcker on all the Sunday talk shows to alert the public. But it didn’t.

There are a slew of hearings on the topic of financial reform scheduled over the next few weeks in Congress. It’s not too late to put the idea of a modern-day Glass-Steagall on the table. Instead of playing it politically safe and setting us all up for a larger crash later, Congress should take heed of Volcker. And the 5 year olds. Split up banks into commercial and investment bank entities. Make monitoring them easier. Reduce systemic risk. Don’t just debate about who gets to watch it grow.

Nomi Prins is author of It Takes a Pillage: Behind the Bonuses, Bailouts, and Backroom Deals from Washington to Wall Street (Wiley, September 2009). Before becoming a journalist, she worked on Wall Street as a managing director at Goldman Sachs, and running the international analytics group at Bear Stearns in London.