Six Problems with the GOP Debate on Financial Reform

November 11, 2015

Last night’s GOP debate was the first to have an in-depth financial reform discussion. Unfortunately, the Republicans seemed like they were being introduced to these issues for the first time rather than a reflecting a deep understanding of debates that have been ongoing for eight years. (There was a weird detour into whether or not deposit insurance exists, which I’ll skip, and the less said about their embrace of the gold standard, the better.)

But it’s worthwhile to dig in now, as these talking points will be with us through the rest of the campaign. There are six statements I want to examine, the first four of which I believe to be outright wrong. This misdiagnosis causes Republicans to seek out the wrong solutions in the wrong places. The last two statements are interesting to debate. (Transcript via Washington Post.)

1. Nobody Wants to Be a SIFI

Rubio argued that banks brag about being declared systemically important financial institutions (SIFI) because there are so many benefits to it. Rubio: “We have actually created a category of systemically important institutions, and these banks go around bragging about it. You know what they say to people with a wink and a nod? We are so big, we are so important that if we get in trouble, the government has to bail us out. This is an outrage. We need to repeal Dodd-Frank as soon as possible.”

I’ll up his actually. Actually, institutions declared systemically important fight against it, hard. GE sold off GE Capital, and in the process its chairman said “GE will work closely with [regulators] to take the actions necessary to de-designate GE Capital as a Systemically Important Financial Institution.” They wanted out.

MetLife is suing the government because it was designated SIFI status. Carl Icahn is pushing AIG to break itself up to avoid its SIFI status. JP Morgan sold off 6 percent of its assets to prevent having the highest SIFI capital surcharge applied to them. The Too Big To Fail subsidy that is supposed to explain why people would want SIFI status has shrunk dramatically toward zero since the crisis. There is no bragging. There is solid resistance, as there should be.

2. Capital Is Up

Jeb Bush started off with the correct statement that capital should be higher for the largest banks, but followed with the odd statement that capital is lower under Dodd-Frank. “What we ought to do is raise the capital requirements so banks aren’t too big to fail. Dodd-Frank has actually done the opposite, totally the opposite, where banks now have higher concentration of risk in assets and the capital requirements aren’t high enough.”

This might be a poorly phrased statement (presumably because no one is allowed to say a good thing about an Obama policy, even if you agree with it), because no matter how you measure it, capital is up. According to the Federal Reserve, the following graphic shows that “the aggregate ratio of common equity capital to risk-weighted assets [for the largest 31 firms] has more than doubled from 5.5 percent in the first quarter of 2009 to 12.5 percent in the fourth quarter of 2014.”

This is robust to other measurements. Important capital requirements dealing with size, leverage, and liquidity are higher than those of Basel III in Europe too. We can and should do more, but we should understand it as a continuation of Dodd-Frank rather than a repudiation.

3. The GSE Big Lie

Carly Fiorina: “Government created the problem of a real estate boom. How did we create it? Under Republican and Democrats alike, Fannie Mae and Freddie Mac, everybody gathered together…”

Stop right there. This is what the finance writer Barry Ritholtz calls the Big Lie, the false idea that the government was responsible for the subprime boom through affordability goals in the Community Reinvestment Act (CRA) and through the GSEs. But it wasn’t. This was a Wall Street creation through private-label securitization and the financial engineering that went with it, something that grew outside the world of the GSEs and CRA. Follow the links for more details, but some high-level information:

The GSEs’ market share actually fell from about 50 percent to just under 30 percent of all mortgage originations during the peak bubble years from 2002 to 2005. The losses from 2006 to 2012 at the GSEs were only about 2.7 percent, compared to 5.8 percent at deposit banks and, crucially, 20.3 percent (!) for private-label mortgage securities. The CRA didn’t apply to the lenders making subprime mortgages, because they weren’t part of the normal banking system.

To quote from a recent review by David Fiderer here: The Federal Reserve Board found “no connection between CRA and the subprime mortgage problems.” A subsequent Fed study found “lender tests indicate that areas disproportionately served by lenders covered by the CRA experienced lower delinquency rates and less risky lending.” Per the Minneapolis Fed: “The available evidence seems to run counter to the contention that the CRA contributed in any substantive way to the current mortgage crisis.” These findings were echoed by the Richmond Fed.

The St. Louis Fed posed a question: “Did Affordable Housing Legislation Contribute to the Subprime Securities Boom?” And the data offered a clear-cut answer: “No… We find no evidence that lenders increased subprime originations or altered pricing around the discrete eligibility cutoffs for the Government Sponsored Enterprises’ (GSEs) affordable housing goals or the Community Reinvestment Act.”

Often people will then argue that the GSEs purchased private-label securities and thus were responsible, not noting that this is a reversal of the previous argument. But the data doesn’t come close here. The GSEs never bought more than 15 percent of that market, it didn’t impact their affordability goals, and they bought the most senior slices and avoided the CDOs where losses were concentrated, which we see from the aggregate loss numbers mentioned above.

This was a Wall Street phenomenon, not driven by the federal government. Not understanding this points you in the wrong direction.

4. CFPB Is Not Out of Control

To go along with an industry-funded ad campaign comparing the Consumer Financial Protection Bureau to the Soviets, Carly Fiorina called the CFPB “a vast bureaucracy with no congressional oversight that’s digging through hundreds of millions of your credit records to detect fraud.”

Instead of being some uniquely out-of-control institution, the CFPB is subject to the same type of oversight and institutional design as other banking regulators like the FDIC. Indeed, it’s meant to mimic the structure of the bank-friendly OCC, but instead acting for consumers. Given that other regulators can veto the actions of the CFPB, it’s extra-accountable. Adam Levitin had a great chart on the CFPB’s accountability, which I’m reproducing here:

And as Levitin also notes in American Banker, most of the CFPB data is already public or received through other regulators. It works on aggregate, anonymized account-level data. This means it knows far less than the financial sector knows about your data.

While I think the previous Republican statements are wrong, these last two are interesting for people involved in financial reform.

5. Can Capital End Crises?

Bush made the quizzical argument that if we just raised capital requirements more, then we wouldn’t have to deal with the hard problem of Too Big To Fail and financial crises. The moderator, confused, asked “Ever? There will never be another financial crisis?” Bush responded, “No, I can’t say that. But I can say, if you created higher capital requirements, that’s the solution to this.”

The solution to Too Big To Fail is to have an accountable practice in place for assigning losses. Right now Dodd-Frank gives a strong presumption to bankruptcy courts, with special powers available to the FDIC in case of emergency through a process called “resolution authority.” Some conservatives suggest a special bankruptcy chapter designed to mimic the FDIC, though that introduces just as many problems as it solves.

Capital, unless you are demanding 100 percent equity, won’t solve this. There is always a risk of failure, and thus panic and contagion. As a result, we need a process in place. We shouldn’t remove the one we have, which conservatives want to do, unless we have a better replacement ready to go, which conservatives don’t. We certainly shouldn’t pretend that the issue will simply go away with a higher this-or-that ratio.

6. Something Something Capital Something

Bush’s generic reference to capital requirements (“raise the capital requirements”) reminded me of something that I noticed from the Perry campaign’s platform on financial reform. I’m guessing that the GOP candidates will be incredibly specific on the things they want to repeal, but very vague on the ways they want to make things tougher.

What does Bush or Perry want to do with capital requirements? Toughen current Basel, or toss that overboard for something new? Put extra emphasis on liquidity and stress testing, or just go for straight headline numbers? If you just focus on leverage requirements without risk-weighted capital, how do you deal with the problems this introduces? Is there a better way to have requirements encourage prompt corrective action away from distress?

I have no idea how they’d answer that. And I’m guessing their policy people don’t either. But I do know exactly how they’d want to dismantle the CFPB piece by piece, going after its mission, governance, and funding. I know how they’d eliminate derivatives regulations and make it so regulators have an impossible time declaring a new firm to be systemically important.

Which is to say that financial reformers have become so conditioned to applaud any reference to higher capital that we could easily let a fox wearing a thin layer of capital-enhancing rhetoric into the henhouse. We’ll be sitting around waiting for all the new promised capital requirements from the right while they dismantle piece after piece of hard-fought reform. We are going to need to get harder specifics, in substance and scale, before we allow anyone to say they are a friend of reform as a result of gesturing toward capital requirements.