The Best Solution to Vampire Squid? Calamari

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The great test for the financial services reform bill, if and when it ever gets debated in the Senate, will be what it does to rein in Goldman Sachs, the Wall Street institution famously described by Rolling Stone journalist Matt Taibbi as “a vampire squid jamming its blood funnel into anything that smells like money.”

The bill is being taken up just a week after the Securities and Exchange Commission (SEC) issued civil fraud charges against Goldman for creating mortgage-backed investment vehicles deliberately designed to fail in order to benefit preferred clients. Everyone knows it’s tough to handcuff a squid. So some are advocating for a simpler solution.

Today, Senators Sherrod Brown (D-Ohio) and Ted Kaufman (D-Delaware) proposed a tasty dish of calamari. They unveiled the “Safe Banking Act of 2010,” a commonsense measure to cap the size of the biggest banks as the single best way to prevent future taxpayer bailouts. Their bill will be offered as an amendment in the Senate and will result in the break up of the largest “too big to fail” institutions.

“We can either limit the size and leverage of 'too big to fail' financial institutions now, or we will suffer the economic consequences of their potential failure later," said Kaufman. “Breaking apart too-big-to-fail banks is the necessary first step in preventing another cycle of boom-bust-and-bailout.”

Brown and Kaufman have put their finger on a critical issue that has been ignored in the debate to date. Since Congress passed the Riegle-Neal Interstate Banking Act of 1994, the largest banks have swelled to mammoth proportions. In 1994, the six largest banks had assets equal to 17 percent of Gross Domestic Product (GDP). They now have assets estimated to be more than 60 percent of GDP. A $50 billion industry fund to unwind these institutions as proposed in the Senate bill would hardly be sufficient. The collapse of these “systemically dangerous” institutions could threaten the entire economy.

The Brown-Kaufman amendment says that the big banks cannot not have liabilities greater than two percent of the country’s Gross Domestic Product (GDP). Today that would be about $280 billion. Other financial institutions are capped as well. While this sounds like a tremendously large number, experts like economist Simon Johnson (13 Bankers) tell us this is the way to go. Such a provision would force the largest banks to shrink down and sell off some assets to fit under the cap. A few of these institutions already exceed a larger cap provided for in current law.

Why is this the best solution to the “too big to fail” problem? The 2008 financial crisis was met with the most extreme and sustained government intervention in the market that we have seen since the New Deal era. Policymakers on both sides of the aisle have recognized that the dramatic actions by the U.S. government to prop up the financial system may have succeeded in pulling us back from the brink, but introduced a whole new era of moral hazard. Many U.S. financial services institutions have been deemed “too big to fail” and have been granted the implicit guarantee of the U.S. government for the foreseeable future. For the first time, this federal backstop has been granted to investment banks like Goldman engaged in speculative activities, not just traditional commercial banks.

There has been an ongoing dispute between Democrats and Republicans over how to tackle the too big to fail problem and put an end to government bailouts. Both groups say that their various policy prescriptions will “end” too big to fail. They are both wrong. In a crisis, the Federal Reserve will do whatever it takes to save these institutions. The only way to put an end to unlimited taxpayer bailouts is to break up the too-big-to-fail banks that currently exist and to prevent them from growing that big in the future.

Other amendments to the bill will crack down on Goldman as well, including provisions to rein in derivatives trading, restore Glass-Steagall depression-era protections and new rules to ban conflict of interest trading.

Tackling the Vampire Squid and other big banks does not have to be complicated. It can even be tasty, with a little side of linguine.