The largest U.S. banks are accused of causing problems in markets ranging from energy to aluminum. Regardless of whether they’re guilty of market-rigging, as critics say, the charges raise another question: Why are the banks in these businesses in the first place?
Part of the answer is that they’re among the country’s most subsidized enterprises. The Federal Deposit Insurance Corp. and the Federal Reserve, both backed by taxpayers, provide an explicit subsidy by ensuring that banks can borrow money in times of market turmoil. Banks that are big and connected enough to bring down the economy enjoy an added implicit subsidy: Creditors will lend to them at low rates on the assumption that the government won’t let them fail.
The recent mini-scandal in the aluminum market shows what happens when banks have access to cheaper financing. Taxpayer subsidies gave the banks an edge in holding the metal. Subsidized financing—made particularly cheap by the Fed’s efforts to stimulate the economy with near-zero interest rates —encouraged banks and their clients to build bigger stockpiles than they otherwise would have, tying up supplies. If the bets were to go wrong and lead to distress at a big bank, the Fed would have to provide emergency financing for an activity that taxpayers never intended to support.
Regulators can reduce the implicit subsidy by requiring banks to fund themselves with more loss-absorbing equity, thus making them less likely to require government bailouts. The so-called Volcker Rule, mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, can limit banks’ ability to use the remaining explicit subsidies for speculative trading.
Congress could also revive the Depression-era Glass-Steagall Act, which would strictly limit all federally insured banks to the business of taking deposits, lending, and processing payments. Such a move would force the breakup of many large diversified financial institutions. Bankers lobbying against the Volcker Rule and other less forceful limits on their activity should ask themselves if that is the course they want bank regulation to take.