We Need a Banking System That is "Too Safe to Fail"

As Congress works to pass financial regulatory reform in the coming weeks, reducing systemic risk by eliminating conflicts of interest and addressing banks deemed "too big to fail" should be some of our top priorities.
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It has been well over a year now since the bursting of a massive speculative bubble, fueled by Wall Street greed and excess, brought our entire financial system to the brink of disaster.

The resulting economic crisis, the worst since the Great Depression, has had profound effects on regular, working-class Americans in the form of millions of job losses and home foreclosures, to say nothing of the hundreds of billions of taxpayer dollars used to prop up failing institutions deemed "too big to fail."

In the coming weeks, the Senate will begin consideration of landmark financial regulatory reform legislation.

As it does, we owe it to the American people to ensure that never again will the risky behavior of some Wall Street firms pose a mortal threat to our entire financial system. The rest of us simply cannot afford to pay for the mistakes of the financial elite yet another time.

As we look to build a better, more durable, more responsible financial system, we must reflect on the fateful decisions and mistakes made over the past decade that led us to this point.

We can begin with Congress' repeal of the Glass-Steagall Act. Glass-Steagall was adopted during the Great Depression primarily to build a firewall between commercial and investment banking activities.

But the passage of the Gramm-Leach Bliley Act of 1999 tore down that wall, paving the way for a brave new world of financial conglomerates.

These institutions sought to bring traditional banking activities together with securities and insurance businesses, all under the roof of a single "financial supermarket."

This was the end of an era of responsible regulation. It was the beginning of an emerging laissez-faire consensus in Washington and on Wall Street that markets could do no wrong.

Not surprisingly, this zeitgeist of "market fundamentalism" pervaded regulatory decisions and inaction over the past decade.

It allowed derivatives markets to remain unregulated, even after the Federal Reserve had to orchestrate a multi-billion dollar bailout of the hedge fund Long Term Capital Management, which had used these contracts to leverage a relatively small amount of capital into trillions of dollars of exposure.

It also provided a justification for the Federal Reserve and other banking regulators to ignore widespread instances of predatory lending and deteriorating mortgage origination standards.

It prompted regulators to rely upon credit ratings and banks' own internal models, instead of their own audits and judgments, when determining how much capital banks needed to hold based upon the riskiness of their assets.

Perhaps most importantly, this era of lax regulation allowed a small cadre of Wall Street firms to grow completely unchecked, without any regard to their size or the risks they took.

In 2004, the Securities and Exchange Commission established a putative regulatory oversight structure of the major broker-dealers, including Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch and Bear Stearns, that ultimately allowed these firms to leverage themselves more than 30 times to 1.

Emboldened by the careless neglect of their regulators, these Wall Street institutions constructed an unsustainable model punctuated by increasingly risky behavior.

For example, some firms used trillions of dollars of short-term liabilities to finance illiquid inventories of securities, engage in speculative trading activities and provide loans to hedge funds.

When their toxic assets and investments went south, these highly-leveraged institutions could no longer roll over their short-term loans, leading them - and all of us - down a vicious spiral that required a massive government bailout to stop.

Despite this extremely painful experience, Wall Street has resumed business as usual. Only now, the business is even more lucrative.

The financial crisis has led to the consolidation of Wall Street.

The survivors face less competition than ever before, allowing them to charge customers higher fees on transactions, from equities to bonds to derivatives.

In addition, in the wake of the financial crisis, markets remain volatile and choppy. Firms willing and able to step into the breach have generated higher returns.

Until this Congress acts, there is no guarantee that the short-term trading profits being reaped by Wall Street today won't become losses born by the rest of America down the road.

As many of my colleagues know, I have come to the floor repeatedly to warn about the short-term mindset on Wall Street, embodied by the explosive growth in high frequency trading.

In just a few short years, high frequency trading has grown from 30 percent of the daily trading volume in stocks to as high as 70 percent. It has been reported that some high-frequency firms and quantitative-strategy hedge funds have business relationships with major banks, allowing them to use their services, credit lines, and market access to execute high-frequency trading strategies.

Under some of these arrangements, these Wall Street banks are reportedly splitting the profits.

In other cases, the major banks have built their own internal proprietary trading desks.
These divisions often use their own capital to "internalize," or trade against, customer order flow.

Such a practice poses inherent conflicts of interest: brokers are bound by an obligation to seek the best prices for their clients' orders, but, in trading against those orders, firms also have a potential profit-motive to disadvantage their clients. Both of these arrangements are evidence of a greater problem: Wall Street has become heavily centered on leverage and trading.

Undoubtedly, short-term strategies have paid off for banks. In fact, much of the profits earned by our nation's largest financial institutions have been posted by their trading divisions.

But an emphasis on short-term trading is cause for concern, particularly if traders are taking leveraged positions in order to maximize their short-term earning potential.

By doing so, such high frequency strategies, which execute thousands of trades a second, could pose a systemic risk to the overall marketplace.

In short, Wall Street once again has become fixated on short-term trading profits and has lost sight of its highest and best purposes: to serve the interests of long-term investors and to lend and raise capital for companies - large and small - so they can innovate, grow and create jobs.

As I've spoken about on the Senate floor previously, the downward decline in Initial Public Offerings for small companies over the past 15 years has hurt our economy and its ability to create jobs.

While calculated risk-taking is a fundamental part of finance, markets only work when investors not only benefit from their returns, but also bear the risk and the cost of failure. What is most troubling about our situation today is that on Wall Street, it is a game of heads I win, tails you bail me out.

The size, scope, complexity and interconnectedness of many financial institutions have made them "too big to fail."

Moreover, the popularity of the "financial supermarket" model further raises the risk that insured deposits of banks can be used to finance speculative proprietary trading operations.

Unfortunately, these risks have only been heightened by recent decisions by the Federal Reserve: the first to grant Bank Holding Company charters to Goldman Sachs and Morgan Stanley; the second to grant temporary exemptions to prudential regulations that limit loans banks can make to their securities affiliates.

There are a number of ways we can address these problems.

The major financial reform proposals being considered in Congress propose some entity for identifying systemically risky firms and subjecting them to heightened regulation and prudential standards, including leverage requirements.

In addition, these proposals also include an orderly mechanism for the prompt corrective action and dissolution of troubled financial institutions of systemic importance that is typically based upon the one already in place for banks.

Although both of these ideas are vital reforms, they are not sufficient ones.
Instead, we must go further, heeding some of the sage advice - as President Obama has today - provided by Paul Volcker.

Chairman Volcker has said: "[Commercial banking] institutions should not engage in highly risky entrepreneurial activity. That's not their job because it brings into question the stability of the institution...It may encourage pursuit of a profit in the short run. But it is not consistent with the stability that those institutions should be about. It's not consistent at all with avoiding conflicts of interest."

I strongly support the ideas Chairman Volcker has recently put forward regarding the need to limit the proprietary trading activities of banks.

Indeed, they get at the root cause of the financial meltdown by ensuring Wall Street's recklessness never again cripples our economy.

We can reduce the moral hazard present in a model that allows banking to mix with securities activities by prohibiting banks from providing their securities affiliates with any loans or other forms of assistance.

While commercial banks should be protected by the government in the form of deposit insurance and emergency lending, Chairman Volcker states: "That protection, to the extent practical, should not be extended to broadly cover risky capital market activities removed from the core commercial banking functions."

Such a reform would completely eliminate the possibility of banks even indirectly using the insured deposits of their customers to finance the speculative trading operations of their securities affiliates.

In addition, we can bar commercial banks from owning or sponsoring "hedge funds, private equity funds, and purely proprietary trading in securities, derivatives or commodity markets."

As Vice President Biden aptly and succinctly put it: "Be a bank or be a hedge fund. But don't be a bank hedge fund."

That is why I am pleased to be a co-sponsor of the bill introduced by Senators Cantwell and McCain to reinstate Glass-Steagall, because I thought it was a start to this very important conversation.

Separating commercial banking from merchant banking and proprietary trading operations is an important step toward addressing banks that are "too big to fail."

Additionally, we need to impose restrictions on size and leverage, particularly on the reliance on short-term liabilities, and give regulators additional powers to break apart firms that pose serious threats to the stability of the financial system or others.

Reducing the size and scope of individual entities will limit risky banking behavior, minimize the possibility of one institution's failure causing industry-wide panic and decrease the need to again rescue large failing institutions.

Together, all of these reforms will create a financial system that is "too safe to fail."

We cannot continue to leave the taxpayers vulnerable to future bailouts simply because some large banking institutions wish to pursue short-term trading profits.

For that reason, as Congress works to pass financial regulatory reform in the coming weeks, reducing systemic risk by eliminating conflicts of interest and addressing banks deemed "too big to fail" should be some of our top priorities.

Separating core banking franchise from speculative activities, imposing tighter leverage requirements and examining the complicated relationships between high frequency traders and banks constitute critical steps toward ensuring our financial markets are strong and stable.

By adopting these common-sense proposals, we can go a long way toward stabilizing our economy, restoring confidence in our markets and protecting the American people from a future bailout.

America cannot afford another financial meltdown and the American people are looking to Congress to ensure that that does not happen.

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