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How Would Democratic Presidential Hopefuls Reform Wall Street?

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In recent years, parts of the financial sector have behaved badly—and holding the relevant executives accountable has not been a strong suit of the Obama administration. So financial reform is an important issue for the country, and whoever wins the Democratic Party presidential nomination will find that it resonates with many voters in the general election.

Former Secretary of State Hillary Clinton, Senator Bernie Sanders, and former Maryland GovernorMartin O'Malley have each put forward detailed and specific plans, including more action by the Justice Department.

[T]he good news is that … the policies proposed by all three candidates are sensible and could make a difference.

All of them also agree that the 2010 Dodd-Frank Act moved some issues in the right direction, but there remains a substantial and important, unfinished agenda. The principal disagreement among the three camps comes down to this: What is the structural problem with our financial system, and how should we fix it?

Senator Sanders and Governor O'Malley correctly point out that in recent decades some banks became very large, and the crisis did nothing to shrink their balance sheets. These banks are commonly and accurately regarded as "too big to fail," meaning that they benefit from an implicit government guarantee. This is a dangerous and unfair subsidy.

Secretary Clinton's plan has a different emphasis. To her, the main problem is the broader fragility of finance—including the ease with which "runs" by creditors can take place in the nonbank financial sector. These runs can be disruptive even when the individual firms involved are not large; this was the experience, for example, with money market funds in September 2008.

But the good news is that both sides are right, and the policies proposed by all three candidates are sensible and could make a difference.

In a forceful speech on January 5, Senator Sanders stressed that he wants first and foremost to break up the largest banks; that would definitely reduce their ability to access government support—and it would level the playing field within finance.

Governor O'Malley has the same goal; both he and Senator Sanders want to pass a modernized version of the Glass-Steagall Act that would restrict the scope of activities allowed within banks. Such a law will be hard to pass as long as the Republicans control the House of Representatives. But there is room for executive action—including the appointment of well-qualified people with similar ideas to the Federal Reserve System's Board of Governors. Senator Sanders would put the Treasury Department in charge of moving this forward; there is nothing implausible or inconsistent with precedent in what he proposes.

In contrast, Secretary Clinton wants more safeguards and buffers against losses across a wide range of transactions (including in the rules for trading all kinds of securities). She is also in favor of reducing the size of the largest banks but prefers to do so with a tax on those firms' liabilities—a potentially significant disincentive.

There has been bipartisan support for this idea in the past—including from Republican Congressman Dave Camp when he was chair of the House Ways and Means Committee. But the current Republican leadership of the House of Representatives has shown no inclination to head in this direction. Taxes of this kind require legislation and the odds are against passage, but in principle Secretary Clinton also is willing to create a similar result by raising capital requirements, i.e., insisting that the largest banks fund themselves with more equity and relatively less debt.

(As a practical matter, the best way forward for the next president likely includes requiring very large banks to fund themselves with relatively more equity. Senators Sherrod Brown (D-Ohio) and David Vitter (R-Louisiana) have a very sensible proposal along exactly these lines.)

There remains some question as to whether Secretary Clinton would, once elected, really want serious financial reform. Her husband oversaw a considerable amount of financial sector deregulation during the 1990s—and some of his advisors from that episode remain unconvinced of the need for any further reform today.

Secretary Clinton's likely actions in this regard are hard to precisely predict, but the leading role of Gary Gensler in her campaign is reason for encouragement. Mr. Gensler was chairman of the Commodity Futures Trading Commission (CFTC) from May 2009 through January 2014, where he worked long and hard to make derivatives safer. He has a clear vision of what is needed next and a smart sense of how to get things done. Last week he made his case this way:

"Secretary Clinton's far-reaching Wall Street reform plan is intended to tackle risk wherever it may arise—whether in the traditional banking sector or the larger nonbank or so-called 'shadow banking' sector, which by a number of measures is conservatively estimated at more than $13 trillion in the United States alone. In the banking sector, she has made proposals to lower reliance on unstable short-term funding and reduce the size of the largest banks, including a risk fee backed up with higher capital requirements. In the shadow banking sector, Secretary Clinton's comprehensive proposals focus not only on the largest nonbank institutions but also critically on the activities that can spark devastating financial runs."

Mr. Gensler previously worked at Goldman Sachs (in the 1990s) but given his track record at the CFTC, that private sector experience should only be regarded as strengthening his reform credentials. He also has a considerable amount of other relevant political experience, including at the Treasury Department in the 1990s and with then-Senator Clinton's 2008 presidential campaign.

Senator Sanders and Governor O'Malley have the advantage of less baggage and perhaps a more forceful message on financial reform. But I'm taking Secretary Clinton's financial reform promises seriously—in large part because Gary Gensler and his colleagues have good ideas and, if given the opportunity, would turn these into sensible policy.

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