Why the Next President Must Reform Wall Street

Part of the Series

Beyond the Sound Bites: Election 2016

“The business model of Wall Street is fraud. It’s fraud. I believe that corruption is rampant, and the fact that major bank after major bank has reached multibillion-dollar settlements with the United States government when we have a weak regulatory system tells me that not only did we have to bail them out once, if we don’t start breaking them up, we’re going to have to bail them out again, and I do not want to see that happen…”—Bernie Sanders in a one-on-one debate with Hillary Clinton.

Some of the many reforms suggested by Sen. Bernie Sanders in the 2016 presidential race focus on Wall Street reforms. Along with bridging the wealth inequality gap, he talks about taking some stringent steps to regulate some of the biggest banks by breaking them up.

Here are a few of the reforms proposed by Bernie Sanders that could be a concern to some of the most powerful on Wall Street.

A 21st Century Glass-Steagall Act

Sanders proposes to break up big banks that are “too big to fail” by supporting a “21st Century Glass-Steagall Act.” In the February 4 Democratic debate, he said, “If Teddy Roosevelt were alive today, a good Republican by the way, what he would say is: Break them up; they are too powerful economically; they are too powerful politically.”

For more original Truthout election coverage, check out our election section, “Beyond the Sound Bites: Election 2016.”

Many economists believed that the integration of commercial banking with investment banking, which was allowed under the repeal of the Glass-Steagall Act, deepened the 2008 crisis. The repeal of the Glass-Steagall Act was called the Gramm-Leach-Bliley Act. The Glass-Steagall Act was passed in 1933 in response to a number of bank failures that happened after the Great Depression. It separated commercial banking activities from risky investment banking activities. But the act was repealed in 1999 under President Bill Clinton after $300 million worth of lobbying efforts. He believed that the act was “no longer appropriate to the economy in which we live. It worked pretty well for the industrial economy … But the world is very different.”

After the repeal, the investment banks resorted to risky trading, since such activities remained largely unregulated. These non-bank financial institutions were known as “shadow banks” and were not subjected to traditional banking regulations. They remained in the shadows of the traditional banking system and channeled funds from savers to investors through a range of funding techniques. The shadow banks earned enormous profits from reckless derivatives trading, and their interlinkages with commercial banks and insurance institutions made the risk systemic in nature. Another act that left the multitrillion-dollar derivatives market unregulated was the Commodity Futures Modernization Act, which was signed into a law in 2000. The act allowed inclusion of some of the most complicated derivatives, like mortgage-backed securities and credit-default swaps. In a loosely regulated environment, these risky products brought in lots of uncertainty to the financial system.

Eventually, the banks became so leveraged and huge that in the event of a failure, they posed a huge systemic threat to the entire economy. The estimated value of the derivatives holdings on banks’ balance sheets had expanded from $88 trillion in 1999, to a whopping $672 trillion by 2008. During the subprime mortgage crisis, the banks were bailed out with taxpayers’ money to prevent financial contagion from spreading to the entire financial system. In 2015, Forbes reported that according to the special inspector general for the Troubled Asset Relief Program (TARP), the total commitment of the US government was $16.8 trillion, out of which $4.6 trillion had already been paid out. TARP was created by the US Treasury to stabilize the economy and prevent any foreclosures in the wake of the 2008 financial crisis.

In 2014, The New York Times reported that US banks still held huge amounts in derivative trading. “American banks have nearly $280 trillion of derivatives on their books, and they earn some of their biggest profits from trading in them,” the Times reported. Some of the biggest banks, like JPMorgan Chase, Bank of America and Wells Fargo, are already 80 percent bigger than they were since they were last bailed out.

Reforming the Wall Street Business Model

In a one-on-one debate with Hillary Clinton on February 4, 2016, Sanders highlighted the seriousness of the banking scandals not being treated as criminal offenses. He said, “Kid gets caught with marijuana, that kid has a police record. A Wall Street executive destroys the economy, $5 billion settlement with the government, no criminal record.”

The 2008 financial crisis left many scarred due to the greed of the most powerful in the financial system, but post-2008, the banking system witnessed a series of banking crimes. Banking scandals like money laundering, insider trading and foreign exchange rigging involved some of the biggest banks. The concerned CEOs and the involved bank executives either voluntarily stepped down or were sacked in an event of fraud detection. In August 2015, Tom Hayes, a former trader at UBS and Citigroup, was sentenced to 14 years in prison for his alleged role in what was known as the Libor scandal.

Hayes was convicted of attempting to fraudulently manipulate the London interbank offered rate, or Libor, which is the interest rate that banks charge one another for loans in the London market, according to Bloomberg. Galleon Group hedge fund founder Raj Rajaratnam made $63.8 million in illicit profit from 2003 to 2009. He traded in stocks such as eBay Inc., Goldman Sachs Group Inc. and Google Inc., and was sentenced in 2012. The New York attorney has identified 70 additional hedge funds, but the prosecution for them has been very slow.

As of May 2015, global banks have paid more than $9 billion in fines, with many traders and brokers being fired, barred and forced to resign. Many of the banking crimes were related to subprime mortgage lending. In a recent settlement, the world’s largest mortgage lender, Wells Fargo, agreed to pay $1.2 billion for engaging in reckless lending under a Federal Housing Administration program.

Reforming the Credit Rating Agencies

Sanders proposes to turn credit rating agencies into nonprofit organizations and make them independent from the shadow of Wall Street. Credit rating agencies (CRAs) give ratings to financial products and sovereigns and these ratings help investors decide which product is safe for investing. Hence, the role of CRAs remains crucial to the economy and investors.

Many of the CRAs were involved in providing inaccurate ratings to products that turned toxic during the 2008 financial collapse. The CRAs knew about the risk of the speculative mortgage-backed derivatives, but still gave them AAA ratings. Currently, the “big three” CRAs – Standard & Poor’s (S&P), Fitch Ratings and Moody’s Investors Service – control 95 percent of the credit ratings market, with very little competition from any major player in the market.

Sanders aims to make the CRAs independent of Wall Street and to do away with the “issuer-pays model” under which the CRAs operate. The model allows a bond’s issuer to pay an agency or agencies for initial ratings and for ongoing ratings. The big three CRAs were criticized for behaving as monopolies during the crisis and providing investors with biased ratings that were inaccurate and lacked transparency. In 2015, a lawsuit alleged that S&P issued inflated ratings that misrepresented securities’ true credit risks. Many investors, mostly federally insured financial institutions, lost billions of dollars on collateralized debt obligations (CDOs). Finally, S&P agreed to pay $77 million, in addition to being banned for one year from rating commercial mortgage-backed securities.

Many of the suggested Sanders reforms address the issue of the 2008 financial crisis, including the issue of banks being “too big to fail.” A document signed by 170 of the nation’s top economists has supported the Wall Street reforms proposed by Sanders. In the document, they write, “The only way to contain Wall Street’s excesses is with reforms sufficiently bold and public they can’t be watered down. That’s why we support Senator Sanders’s plans for busting up the biggest banks and resurrecting a modernized version of Glass-Steagall.”

The Importance of Community Banks

The 21st Century Glass-Steagall Act and breaking up big banks will surely also encourage the growth of a traditional community banking system that has been adversely affected by the rise of “too-big-to-fail” banks (that have easy access to huge funds). Community banks are roughly defined as small banks that carry an asset size of less than $10 billion. They are vital to local communities as they work on building long-term relationships with their customers. Community banks focus on the needs of local families, businesses and farmers, and provide small loans for local and agricultural businesses. A 2015 Harvard University study found that they provide 77 percent of agricultural loans and 50 percent of small business loans.

But the 2008 crisis and implementation of strict regulations under Dodd-Frank have put this important sector under immense pressure. The cost of sustenance in the current banking environment under expensive regulations has become a challenging factor for many community banks, resulting in mergers or shutdowns. Community banks have seen a decline of 12 percent in their shares of assets since the introduction of Dodd-Frank regulations in 2010. This section of the small banking system had little role to play in the 2008 financial crisis, yet it had to face the repercussions in the form of stringent banking rules. According to the Federal Reserve Bank of Kansas City, “community banks are not major participants in large-dollar wholesale payments systems” and hence “they pose little or no systemic risk to the overall financial system.” Sanders’ approach toward big banks and breaking them up will help bring back the traditional community banking system and promote healthy and fair competition in the industry.

Breaking up big banks, instating a 21st Century Glass-Steagall Act, restructuring the rating methodology of credit rating agencies and holding bankers accountable for their banking crimes are likely to address some relevant and pending issues on Wall Street.