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6 Ways to Reform Our Corrupt Financial System

We must tame the growth of wealth among the top 1 percent and establish rules and institutions that ensure security and opportunity for the middle class.

Photo Credit: blvdone / Shutterstock.com

The following is an excerpt from the new book Rewriting the Rules of the American Economy by Joseph E. Stiglitz (W. W. Norton & Company, Inc., 2016):

The growth of the top 1 percent was enabled by specific policy decisions. It occurred when we removed safeguards that protected consumers and taxpayers from excesses in the financial industry and failed to update other common-sense regulations. It occurred when corporations cast aside their own long-term interests in favor of short-term stock gains for shareholders and distortionary CEO pay packages. It occurred when we restructured the tax code in ways that led to more leverage and higher executive pay, as opposed to more investment in productive assets. Addressing these issues doesn’t just address inequality; doing so will also build a solid foundation for the economy of the 21st century.

We must curb the current system’s risks to the overall economy and curtail practices that directly cost consumers. Here is an agenda that ends “too big to fail,” reduces the risks in “shadow banking,” increases financial market transparency, makes a more efficient payments mechanism by limiting credit and debit card fees and enhancing competition, enforces rules with stricter penalties, and reforms Federal Reserve governance. 

End “Too Big to Fail”

We have yet to undertake the reforms needed to end too big to fail and thus reduce the potential for failure of large financial institutions to damage the broader economy. Banks that are backed by the government and are so big that their failure will cause the entire economy to contract don’t need to internalize the costs of their failures and can reap huge benefits from risky bets. They have a perverse incentive to take on excess risk, knowing that should a problem arise they will be bailed out, with losses being borne by others. This, of course, is exactly what occurred in the 2008 financial crisis, the impacts of which still reverberate throughout the economy.

Despite recent experience and the Dodd-Frank reform, banks are still not only too big to fail, but also too big to manage—evidenced by repeated failures like the “London Whale.” And even when they are not too big to fail, they can be too interconnected, too interlinked to fail: with excessive linkages (e.g., those associated with CDs and derivatives), the failure of one institution can lead to a cascade of other failures—stoppable only with a government bailout. That is why interlinkages need to be transparent and regulated.

The Financial Stability Oversight Council should assess large, systemically risky financial firms with an additional capital surcharge above what regulators currently assess under the Basel Accords in order to make failure less likely and more manageable. Moreover, being too big to fail (or too interconnected to fail) gives banks an advantage: they don’t have to account for the costs their failure poses to the system as a whole, and get a subsidy as a result. The surcharge corrects for a market distortion that otherwise would favor such banks, even if they are not more efficient than smaller ones.

A surcharge would force banks to internalize the true cost of their risks and improve economic efficiency, while insulating taxpayers from the costs of failed institutions. And, to avoid the unproductive debate over how to exactly quantify “systemically important financial institutions,” the requirements should be graduated rather than set to a specific level.

Further, if firms are incapable of producing “living wills” that the Federal Reserve and the Federal Deposit Insurance Corporation believe show how they can unwind in bankruptcy without causing massive costs to the rest of the economy, then these institutions need to be broken up along business lines and by size so that potential failures can be better managed. In addition, living wills and their analyses should be made public. The wills have to be designed to work not just in normal times but also in the abnormal times associated with a financial crisis. Some doubt whether meaningful living wills can in fact be constructed, given the kind of turmoil that can arise in the midst of a crisis. If this is the case, then the only recourse is to begin the process of breaking up the too big to fail institutions in the same way we once broke up Standard Oil and AT&T.

Regulate the Shadow Banking Sector and End Offshore Banking

Among the too-big-to-fail financial institutions are shadow banks, which are nonbank financial institutions that engage in lending by trading bonds and securities, often by bundling them through a process called securitization. They include money market funds, insurance companies like AIG, and even automakers. Even though these nonbank financial institutions were integral to the causes of the financial crisis, with many of them having to be bailed out, post-crisis reform hasn’t done enough to address the enormous risks inherent in the sector’s opaque activities and non-arms-length lending.

The shadow banking sector continues to grow while remaining insufficiently regulated. In fact, much of the activity in the shadow banking system is motivated not by its greater efficiency but simply to circumvent regulations designed to ensure the stability and efficiency of the financial system. We must not only address the regulatory defects that have allowed this sector to grow too fast. The crisis revealed that our regulatory structure was not up to the task; it hadn’t adapted to the new ways that credit was provided within the shadow banking system. But by general consensus, in the aftermath of the crisis, the shadow banking system continues to be inadequately regulated. It is a matter of choice that we have failed.

For instance, regulation should improve transparency in the entities considered shadow banks. As just one example of how to increase transparency, the Securities and Exchange Commission should reevaluate and expand on its recent ruling on money market mutual funds, whose vulnerabilities in the 2008 financial crisis sparked a panic. The ruling required that all money market mutual funds be valued on a floating basis reflecting the value of their underlying assets, rather than a fixed price of $1 per share. A good expansion would be to apply the floating values rule to all money funds. This rule would help shore up money market risk, and in particular, reduce the likelihood of panics.

We also need to clarify the government’s role as a lender to these nonbank financial institutions. The current ambiguity increases overall risk. During the 2008 financial crisis, the Federal Reserve radically expanded its ability to function as a lender of last resort and provided liquidity services to the shadow-banking sector, thus expanding the too-big-to-fail subsidy to an even broader set of institutions. Emergency lending is crucial in a crisis, and is one of the powers the federal government has to help mitigate the risk of a financial panic. But without clear rules, guidelines, and limits, these powers can become subject to serious abuse. As a result, Congress, under the Dodd-Frank Act, requires the Federal Reserve to only establish an “emergency lending program or facility [that] is for the purpose of providing liquidity to the financial system, and not to aid a failing financial company” in a crisis. The Fed was required to establish clear procedures to meet that goal but has dragged its feet, writing a weak rule that insufficiently clarifies its role. The Federal Reserve must write clear rules outlining the government’s role in back-stopping the shadow banks. It must ensure the regulatory framework is sufficiently strong that such back-stopping is truly a rare event and it must impose charges on the shadow banking system for the costs imposed on society and the risk of potential bailout costs. Congress should take action if the Federal Reserve makes no progress in writing these rules.

Most importantly, there needs to be a re-examination of the extent to which shadow banks and offshore financial centers are used to end-run the regulations designed to ensure a safe and sound financial system. It is hard to understand what true economic advantages—other than regulatory circumvention—Cayman Islands or other offshore banking centers have over those located onshore. The U.S. has the requisite financial expertise—indeed, much of the management of the offshore accounts is actually done in the U.S.

Bring Transparency to All Financial Markets

Opaque activities in finance are not limited to credit intermediation. The uncompetitive and often undisclosed fees associated with asset management, particularly those from alternative management vehicles like private equity funds and hedge funds, are a driving source of financial sector growth, profits in that sector, and the income share of the top 1 percent. Furthermore, most investors in IRAs and other financial products don’t understand the rules under which they operate—that the managers of such funds are not even held to a fiduciary standard and can be conflicted. Of course, any excess fee is simply a transfer of wealth from regular investors in these pension funds or savings vehicles to those in the financial sector.

Already, thanks to a provision of Dodd-Frank that requires private equity to register with the SEC, significant amounts of fraud or substandard behavior have been disclosed. As the director of the SEC’s Office of Compliance Inspections and Examinations put it after investigating a sample of 150 newly registered private equity advisers: “we have identified what we believe are violations of law or material weaknesses in controls over 50 percent of the time.” Congress should expand the SEC’s mission, and require private equity and hedge funds to disclose holdings, returns, and fee structures. The SEC should provide additional regulatory scrutiny and investor advice on these deals. This will formalize their regulation, making it similar to mutual fund regulations; the competition that will follow from this price transparency will help reduce financial rents. 

Reduce Credit and Debit Card Fees

High consumer fees on credit and debit card transactions are one clear symptom of abuse of market power in the financial sector. Modern technology should enable the transfer of money from an individual’s bank account to that of the merchant from whom he or she is making a purchase to cost but a fraction of cent. Instead, the fees credit and debit card companies charge merchants—often 1–3 percent or more of the cost of the transaction—do not reflect the cost of services provided but rather a monopoly rent on the country’s networked payments infrastructure. Ironically, financial institutions often lobby against taxes that increase transaction costs at far lower rates by arguing that the added fee will hurt business.

The Durbin amendment to the Dodd-Frank bill was supposed to bring down the excessive fees that the debit card companies impose on merchants (and which are passed along to consumers in the form of higher prices). Increased prices from monopoly power, as we noted, are just as important in lowering standards of living for ordinary Americans as decreased nominal wages. But Dodd-Frank delegated responsibility for the implementation of the regulation to the Federal Reserve, which has not sufficiently reduced the fees. Further, the Durbin amendment was limited to debit cards, leaving the even more important credit card market open to unrestrained monopoly power. Recent court decisions hold open the promise that the market will be more competitive in the future, but we should not rely on this. We need to make sure that the market acts competitively, and that the financial sector does not exploit its market power over the payments mechanism.

Enforce rules with Stricter Penalties

The enforcement of the rules is just as important as the rules themselves. And in the past decade there’s been a shift away from strict criminal enforcement of financial regulation. Fewer, if any, cases go to court. Instead the SEC and the Justice Department settle with favorable conditions, such as deferred prosecution agreements. Under these agreements, the parties regularly don’t admit to any wrongdoing, or even pay penalties commensurate to their benefits. No individual is held directly accountable. The fines that are paid come from shareholders and are tax deductible; the perpetrators of the offenses aren’t necessarily punished or made to give back the compensation they received as a reward for the extra profits generated by their illegal activities. Enforcement has swung toward these favorable deals instead of serious consequences and convictions for wrongdoing.

The firms promise not to engage in the proscribed activity (which they have not admitted doing), but then they are repeatedly hauled up for engaging in similar activities. It is clear that the kind of enforcement we have is not acting as a sufficient deterrent.

The SEC and other regulatory agencies should instead focus on more strict enforcement, and Congress should hold the agencies accountable if no progress is made. No company should be able to enter into a deal like a deferred prosecution agreement if it is already operating under such an agreement. These agreements should face stricter judicial review and scrutiny. And compensation schemes should be designed so that perpetrators face significant consequences—for instance, a clawback of bonuses and a reduction in retirement benefits.

Reform Federal Reserve Governance

The mindset of who enforces these rules also matters. Many of the regulations in the financial sector are enforced by the Federal Reserve. And the leadership at the Federal Reserve is too often influenced by the largest financial interests rather than by small lenders and borrows. Reforms to the governance structure of the Fed should focus on reducing the conflicts of interest that seem so apparent and reforming the process by which officials are chosen.

Concern about the Fed’s behavior has focused mostly on its conduct of monetary policy and the management of the 2008 bailout.

On the right, many argue for a rules-based system—monetarism, under the influence of Milton Friedman, called for the money supply to increase at a fixed rate. But the evolving structure of the economy largely discredited such theories and their ability to ensure the macro-stability of the economy. On the left, there was a concern that the Federal Reserve reflected more the interests of financial markets, with their focus on inflation, than the economy as a whole, or workers in particular, who were more concerned with unemployment. Even officials who did not come from Wall Street appeared to be “cognitively captured.” These issues received heightened attention in the aftermath of the 2008 crisis, when the Federal Reserve appeared unwilling to disclose many details of what it, together with the Treasury, had done. Among the beneficiaries of the largesse were the institutions whose executives had served on the committees selecting the head of the New York Fed. And numerous reports raised questions about the appropriateness of Fed actions, many of which reflected de facto subsidies, of enormous proportions, to certain institutions. The Fed is a public institution; it has been given public responsibilities in the macro-management of the economy, the conduct of bailouts, and the regulation of the financial system and the governance of the Fed should reflect this.

A 2011 study by the Government Accountability Office found significant scope for improvement in management of conflict of interest within the Fed system. Employees and members of all the regional boards of the Fed should be required to disclose all potential conflicts of interest (defining that very broadly); individuals with any significant conflict of interest should be precluded from employment or membership in the board of any regional Fed; members should be required to recuse themselves from decision making in cases with any possible conflict of interest; and members should be held to a revolving-door agreement that prevents working for the financial industry for some time after their term of service. On top of this, the boards and officers of regional Federal Reserve banks should be chosen in transparent and accountable elections.

***

Our economy is a large and complex system and, in order to solve the problems with that system, we must aim to fix the economy as a whole. The financial crisis of 2008 and the Great Recession that followed exposed the inadequacy of the old economic models; the new research and thinking that has emerged as a result suggests that equality and economic performance are in fact complementary rather than opposing forces. No more false choices: changing course won't be easy in the current environment, but we can choose to fix the rules structuring our system. By doing so, we can restore the balance between government, business, and labor to create an economy that works for everyone. Building on the innovative legacy of the New Deal, we must tame the growth of wealth among the top 1 percent and establish rules and institutions that ensure security and opportunity for the middle class. 

Joseph Stiglitz, a Nobel laureate, is a professor of economics at Columbia University.
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