Who’s Right on US Financial Reform?

CAMBRIDGE – Eight years after triggering a crisis that nearly brought down the global financial system, the United States remains plagued by confusion about what reforms are needed to prevent it from happening again. As Americans prepare to choose their next president, a better understanding of the policy changes that would minimize the risk of future crises – and which politicians are most likely to implement them – is urgently needed.

What Americans are sure about is that they are angry with the financial sector. This is reflected in the success of recent Hollywood movies such as The Big Short (which has been rightly praised for making complex instruments like derivatives broadly understandable). And it is reflected in the current presidential campaign – most notably, in remarkable support for Senator Bernie Sanders’s leftist bid for the Democratic nomination.

At the center of Sanders’s campaign is a proposal to break up the big Wall Street banks into little pieces, thereby ensuring that no bank is so big that its failure would endanger the rest of the financial system. The appeal of that goal is understandable. But achieving it would require a massive sledgehammer.

Though the American banking system historically featured thousands of small banks, the “too big to fail” phenomenon is not exactly new. The first bank that was declared “too big to fail” was Continental Illinois, which received a bailout in 1984 from President Ronald Reagan. With banks now bigger than ever – America’s four largest each held more than $1 trillion in assets in 2011 – breaking them down to the point that no segment is systemically important would be a long and complex process, to say the least. Merely turning the deregulatory clock back 30 years would not do the trick.