Preventing taxpayer bailouts

Watchdog the watchdogs | Fire drills for banks | A “Living Will” for banks | More transparency for risky investments

Back to Wall Street Reform Guide

Many of the largest banks in the country are so big that they have influence over the finances of millions of Americans and businesses. So if one of them collapses, like many banks did in 1929 and again in 2008, it can mean that millions of people lose their money and the economy goes into a tailspin. Following the 1929 Wall Street crash, laws were enacted to help ensure that banks to operate prudently and avoid risky practices. Over the past twenty-five years, those laws were gradually scaled back. Subsequently, many large banks engaged in increasingly high-risk practices – many of which are attributed to the 2008 financial crisis and resulting bailout.

There are two sides to whether or not the bailout was the right thing to do. But there is little question that the more important task is to reinstate and modernize many of the Depression-era rules that kept the banking industry stable – and to ensure the banks, not the public are on the hook in the event of a future collapse.

The Wall Street Reform law includes a number of provisions, in addition to the Volcker rule, designed to ensure that both the banking industry and the government work to keep the banking industry stable. Here are some of the most important provisions:

Watchdog the watchdogs

Problem: Credit rating companies, like Standard and Poor’s, are supposed to speak up when a major bank makes so many risky loans that they put their finances at risk. Unfortunately, the largest credit rating agencies fell down on the job, looking the other way when most Wall Street banks made risky investment decisions. By the time the problem was discovered, the economy collapsed.

Solution: Government watchdogs are now empowered to closely monitor credit rating companies and ensure they perform their duties.  

Learn more:  From the agency largely responsible for regulating credit rating agencies: the U.S. Securities and Exchange Commission

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Fire drills for banks

Problem: With credit rating companies looking the other way, many bank executives ignored obvious signs that their company was at risk – until it was too late.

Solution: New proposed rules will require banks to do periodic “stress tests” of their finances. It works much like those fire drills at school. Banks will be required to run their loans, securities portfolios, and funding operations through various economic scnarios, including periods of rising unemployment and economic decline. They will report areas of weaknesses and their plans to fix them to government watchdogs, who will ensure banks follow through. 

Learn more: Washington Post, 11/22/11, Fed Plans Second Stress Test for Big Banks

From the agencies primarily responsible for stress tests: the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC)

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A “Living Will” for big banks

Problem: When Lehman Brothers and other banks collapsed in 2008, these banks were so huge and complex, it was impossible for the public to quickly figure out who would be affected, and how to best to control the damage so people didn’t lose their money. That made speedy action impossible at a time when it was essential.

Solution: Now, banks with $50 billion or more in assets have to create a “living will” so that if that bank collapses, the public and government officials have inside information about the bank, and can more easily figure out how minimize damage to consumers.

Learn more: New York Times, 9/13/11, Regulators Aim to End Too Big to Fail

From the Federal Reserve, the agency responsible for the living will rule.

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More transparency for the most risky investment decisions

Problem: Back in the olden days, banks used to make money through the interest on loans to businesses and consumers, which is a relatively stable activity. In recent years, however, many banks shifted to making profit by betting on high yielding but risky and complex trading schemes, such as derivatives. Unfortunately, there were few rules governing these schemes. Many banks bet more money than they could pay back, and bet them on financially unsound schemes. This was a key reason why so many banks collapsed in 2008.

Solution: New rules will require these schemes to operate openly to prevent fraud, ensure banks have enough cash on hand in case their bet fails, and ensure that banks only bet on schemes that have a solid rationale behind them.

Learn more:

Primer on derivatives from the New York Times

From the two federal agencies responsible for regulating derivatives: U.S. Securities and Exchange Commission and U.S. Commodities Futures Trading Commission

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Issue updates

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