Zamarripa: Big Banks Can’t Be Reformed With Small Ideas

Posted April 28, 2010 at 11:01am

Goldman Sachs has quickly become the poster child for financial reform. And now, with enough Senators rejecting closing off debate, Congress may yet have the opportunity to change its reform plans to make sure that it and other big firms can no longer threaten the nation’s economy.

[IMGCAP(1)]While Goldman Sachs didn’t itself go belly up, the facts that it received payouts from Troubled Asset Relief Program funds and now faces fraud charges by the Securities and Exchange Commission underscore the lack of transparency and double dealing that has spread financial risk and made investors so wary. The long delay in bringing the case demonstrates the fundamental inability of regulators to penetrate complicated financial arrangements in a timely manner.

Fortunately, this teachable moment in the history of financial reform has been kept alive by the Senate stopping short of a cloture vote on reform. With a 57-41 vote, the case for sensible reform may yet expand and refine the debate. Congress should use the opportunity to make sure any legislation:

• Imposes limits on leverage and increases margin requirements;

• Breaks up “too big to fail” banks rather than bailing them out;

• Forces derivatives to be traded on open, regulated exchanges without “special designation” that would let some remain in the dark; and

• Holds directors of too-big-to-fail institutions responsible for its failure, not the taxpayers or with fees paid by other investors.

The Obama administration’s efforts to bring derivatives trading into the light of day were a start at reform. Sen. Blanche Lincoln (D-Ark.) introduced a derivatives bill to force their trade onto regulated exchanges, making wheeling and dealing like that by Goldman Sachs less likely to blindside investors and regulators.

Many experts have come to recognize that the swaps and other deals that Wall Street firms put together may have covered up the insolvency not only of some businesses but even a country, Greece. But as the former Labor secretary of the Clinton administration Robert Reich has pointed out, the centerpiece for reform, the bill sponsored by Sen. Chris Dodd (D-Conn.), “preserves the possibility that the [Federal Reserve] could launch another bank bailout.” Indeed, according to Rep. Brad Sherman (D-Calif.), the Dodd bill “contains permanent, unlimited bailout authority.”

The bill would have institutionalized the too-big-to-fail doctrine by putting the Federal Deposit Insurance Corp. in charge of when to close down insolvent firms and have it decide the value of derivatives, neither of which it is truly competent to do.

What regulator would risk a repeat of what happened following Lehman’s collapse? The temptation to bail out rather than work out is just too powerful. Political expediency would trump genuine economic necessity repeatedly, thus institutionalizing too big to fail.

Bankruptcy code and courts provide a better avenue to close failing banks, having worked effectively for more than 200 years. What the code and courts can’t handle is the flight of investors, depositors and others from the kind of risky deals that drove a company like Lehman Bros. into the hole. Lehman, Goldman and American International Group became impulsive institutions, selling products too complicated for the understanding of most investors and even most regulators, in large measure because they began to feel they were too big and important to fail.

The real financial reform is not the Dodd bill, but another proposed by Sens. Ted Kaufman (D-Del.) and Sherrod Brown (D-Ohio), which would place a cap on the size of banks to reduce their threat to the U.S. economy. An amendment by Sens. Jeff Merkley (D-Ore.) and Carl Levin (D-Mich.) would write into law the Volcker Rule separating commercial banking from Goldman Sachs-styled financial gambling.

Kaufman and Brown’s proposal is refreshing in its simplicity and common sense. Just ask yourself: Does it really make sense to have three-fifths of the nation’s gross domestic product concentrated in six mega banks, banks that mimic each others’ activities and risky behavior in the pursuit of profit while knowing Uncle Sam can’t afford to let them fail?

Reducing the size of the mega banks would limit the impact of bank failures and risk-taking on the America public. Smaller banks will improve competition for new services and products while also allowing for long-overdue innovations in business to consumer services.

Big banks also would be worth more to shareholders and investors in parts than as a whole. The only real loss would be the power they hold over Washington from their being too big to fail.

Policymakers should heed the advice of Richmond Fed President Jeffrey Lacker and Dallas Fed President Richard Fisher, who have also called for reforms that would limit the size of banks so they don’t become too big to allow to fail, and to reduce in size those that now are.

It’s time to cut Goldman Sachs and the other mega banks down to size, not promise them bailouts. Sens. Kaufman and Brown offer the tool to do the pruning. Let’s see who in Washington is serious about financial reform.

Sam Zamarripa, a former Georgia state Senator and chairman and co-founder of Stop Too Big to Fail, serves as president and founder of private equity firm Zamarripa Capital and as founding director of United Americas Bank of Atlanta.