Warren's Wall Street Reforms Would Just Make Banks Riskier

Sen. Elizabeth Warren has received a lot of attention for her new plan to complete the work of the Dodd-Frank Act. This plan would sow the financial services ground with salt as Rome did to Carthage, ensuring that nothing will grow in the future. It's hard to understand why someone with her views is called a "progressive." In the past, these opinions were called "reactionary," reflecting a desire to return to the past because of a fear of both the present and future.

Take, for example, the idea of breaking up the largest banks. The contemporary financial world is larger and more complicated than it was in the past, and the biggest banks are one example of that. It might indeed be a good idea to break them up, but one wonders whether Sen. Warren and others have thought this through.

These large institutions are essential to the operations of U.S. companies in the U.S. and around the world — not necessarily for credit but for financial guarantees, payroll operations, currency transfers, financial advice, market making, and a myriad of other activities and services. Who or what will provide these services if the largest U.S. banks are broken up? Turning back the clock to a time of smaller banks, without considering the consequences, is characteristic of reactionaries.

In addition, those who call for the breakup of big banks cite the fact that these institutions are "too big to fail." Okay. Agreed. But what size should they reduced to? Would a $200 billion bank be small enough so that it is not TBTF? As far as I know, Sen. Warren has no better idea than anyone else as to how to answer this question. But she advocates for breakups nonetheless.

If $200 billion is considered the right size, we would have 30 or so of these institutions trying to figure out how to remain profitable without growing beyond that threshold. If the $50 billion threshold at which banks are considered systemically important was proposed as the right size, 120 or so institutions would be in that position. Mergers would be impermissible, so failures among the weakest would be the only recourse. Who would pick up the expense?

The whole point of breaking up big banks is presumably to prevent the taxpayers from having to bail out a large failing bank. But if we break up the largest banks into smaller ones, we make it more likely that the taxpayers will have to bail them out. Whatever can be said about the complexity and risks of large banks, it is still true that large institutions, because of their inherent diversification, are much less likely to fail than smaller ones.

Surely there is a way to protect the taxpayers against bank bailouts without throwing the financial markets and economy into even greater turmoil than Dodd-Frank Act already has.

Then there's the idea of restoring Glass-Steagall. This is another example of an unthinking and reactionary view.

Federal Reserve vice chairman Stanley Fischer just reported a week or so ago that banks now supply only one-third of the credit in the U.S. financial system. Who supplies the rest? Nonbanks like insurance companies, investment funds, broker-dealers, hedge funds, mutual funds and even individuals, all of which are active in the securities and capital markets.

Securities market financing has been out-competing bank lending for 30 years, and now the gap has widened so far that even the Fed has noticed it. But it exists because financing through the capital markets is cheaper than financing through banks. It's what one might call efficiency — even progress — if companies have to spend less for credit and can lower their prices to consumers.

Leaving aside whether these capital markets financing sources should be regulated as "shadow banks" — another bad idea backed by Sen. Warren — it makes no sense to try to keep banks from competing in a financial market that is growing because it supplies its goods and services more cheaply than banks.

But that's exactly what the restoration of Glass-Steagall would do. Since Glass-Steagall's partial repeal in 1999, banking organizations — not banks themselves — have been able to profit from participating through affiliates in the growing capital markets. These entities are often their most profitable parts.

Now try to imagine 120 new banking organizations, each with no more than $50 billion in assets, unable to participate in the capital markets and vying for a shrinking pool of borrowers in an economy that favors less expensive market-based financing. Most of these banks would fail as potential customers moved increasingly to financing through the capital markets. Unlike the biggest banks today, they would not be able to survive on fees from the non-credit services described above. Does this vision of the future seem appealing, or even remotely plausible?

Yet commentators suggest that Sen. Warren's misguided ideas arelikely to pull Hillary Clinton to the left. If they actually do, the bridge to the future of 1992 will become a bridge to the past in 2016.

Peter J. Wallison is a senior fellow at the American Enterprise Institute. His latest book is Hidden In Plain Sight: What Caused the World's Worst Financial Crisis and Why It Could Happen Again.