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What Republicans and Bernie Sanders get wrong about Wall Street

(Reuters/Lucas Jackson)

Nothing gets less respect than incremental change.

Opponents attack it as only the first step in your plan to remake the world, and supporters attack it as, well, the only step in your plan that doesn't actually remake the world. And so the truth gets forgotten somewhere in the middle.

Take the Dodd-Frank financial reform. If you listen to Republicans, it's a job-killing overreach that —did I mention? — has killed jobs, killed banks and killed lending. And if that doesn't scare you enough, they also say it's institutionalized bailouts and will send a robot back in time to retroactively lay you off by destroying wherever you work. (Okay, that last part might be an exaggeration, but only a slight one.) If you listen to Bernie Sanders, though, Dodd-Frank has been borderline ineffectual since it "did not end much of the casino-style gambling" and let the big banks stay even bigger than they were before the crisis. Or, as he has put it over and over again, it hasn't changed the fact that "the business model of Wall Street is fraud."

So there you have it. Dodd-Frank has either done so much that it's crippled the economy or done so little that it's barely clipped the banks. But what does the actual evidence say? Well, first off, the idea that we should go back to the way things were before Lehman became a four-letter word ignores a lot of easy-to-remember history. The fact, as Barry Ritholtz points out, is that it was the big banks, not mortgage giants Fannie Mae and Freddie Mac, who started making so many of the subprime loans that ultimately doomed the economy. So sure, Dodd-Frank has probably slowed the economy down a tad, but for the good reason that it's trying to keep the banks from loaning money to people who can't afford to pay it back.

Indeed, if Dodd-Frank hasn't changed Wall Street, somebody forgot to tell Wall Street that. You can see that in the chart below. It shows how much the financial system as a whole has borrowed the past 35 years. The simple story is that the more debt the banks have, the more vulnerable they are to even small losses. Think about it like this: If you have $10 and borrow $90 more, it'd take a 10 percent loss for you to be bankrupt, but if you only have $3 and borrow $97 instead, then it'd just take a 3 percent loss for you to be wiped out. Bankers, though, love leverage, because it supercharges their returns —and, as a result, their bonuses. That's why banks have borrowed more and more and more whenever the economy was good, and sometimes even when it wasn't.

Until now, that is.

Now, on the one hand, it's not surprising that bank borrowing crashed during the, well, crash. But on the other, it's at least a little surprising that leverage has continued to contract since then despite the fact that the economy's been expanding and there hasn't been another crisis. That hasn't happened at any other time in recent memory. So why do I say that's only a little surprising? Because that's what you would expect when you tell banks that they can't borrow as much — which is part of what Dodd-Frank did. It increased capital requirements, and, lo and behold, banks are reducing their leverage. Wall Street, in other words, isn't allowed to take as many or as big risks as before. The result is a smaller financial system — the big banks cut another 100,000 jobs last year — and a safer one, too.

But does safer mean safe enough? Maybe not. The big banks, after all, are even bigger than they were in 2008 because of all the shotgun marriages back then between banks that were failing and banks that were about to fail. Sanders, for his part, thinks that the best way to deal with this is to break them up based on what kind of business they're in. So instead of having megabanks that take in deposits and sell stocks and bonds, you'd have commercial banks that just did the first part and investment banks that just did the second. That's the same system we had between 1933 and 1999 — what's known as Glass-Steagall — a time when we had precisely zero financial crises. So wouldn't it work again?

Not if we leave the financial system so susceptible to runs. The easiest way to think about this is to realize that there are really two kinds of banks. First, there are the regulated ones that are actually called "banks" and have a safety net to stop any runs from starting. And second, there are the unregulated ones that are called other things — money-market funds, hedge funds, private equity funds and broker-dealers — that are one self-fulfilling panic away from losing your money. The 2008 crisis, then, was the result of a run on this so-called shadow banking system that turned into a run on the regular banking system. Glass-Steagall wouldn't have prevented that. Indeed, it was standalone investment banks such as Bear Stearns and Lehman Brothers that almost dragged down everyone else.

That doesn't mean breaking up the big banks isn't a good idea. It might be — but only insofar as that keeps them from having the clout to roll back other reforms. It's about power, not economics. If we want to make banks safe enough to fail, though, we should do more of what's already working. That might mean bigger capital requirements for bigger banks — which might persuade them to break themselves up — or telling shadow banks that they have to play by the rules, too, and hold more capital themselves. But to do any of that, we have to admit that what's already working is, in fact, working.

What do we want? Incremental change. When do we want it? As soon as there's a president and Congress to give it to us.