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What President-elect Biden can do to fix outdated financial system

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Dear President-Elect Biden:

Your administration stands at an unprecedented financial crossroads. The course you choose will impact the pocketbook of every American for decades to come.

Four years ago, I wrote a similar letter to President-Elect Trump, calling on him to address the exponential regulatory costs since the 2010 Dodd-Frank Act. But a lot has changed since, and your administration faces a whole new set of challenges.

Some will tell you that sound financial regulation is just a matter of rolling back the regulatory policies of the last four years, and writing more and harsher rules. Nothing could be farther from reality.

Financial services in America will only thrive if you appreciate that new delivery systems and new financial products require an overhaul of our obsolete concepts of oversight. Four critical economic and financial challenges lay before you.

Foreign interests threaten U.S. financial stronghold

Much has changed since the Bretton Woods Agreement in 1944 solidified the monetary and economic role of the United States in the world. By many measures, the U.S. is now falling behind in the race for financial and technological superiority.

What is happening in China should be a wake-up call for your administration. The five largest banks in the world are headquartered in Asia — four are in China.

Further, China intends to outspend the U.S. by many multiples over this decade to dominate the development of artificial intelligence, quantum computing and centralized digital currencies. Unless the U.S. ups its game and significantly reorders its priorities, these actions represent significant competitive threats to U.S. financial superiority and the preeminence of the dollar as the world’s reserve currency.

Refocus regulation on the risk, rather than the company

It makes no sense in this technologically enabled financial landscape to prudently regulate financial institutions and not the financial risk in the economy.

Since the 1970s beginning with money market funds, a growing universe of thinly regulated financial companies and products have been slicing off sectors of the financial services business. Nevertheless, the full weight of regulation has fallen on the shoulders of commercial banks and savings institutions, leaving a supervisory structure that is ill-suited to a system that channels risk into unregulated sectors of the economy.

At the same time, the dominance of regulated financial institution has shrunk considerably. Since 1985, the number of banks and savings institutions has decreased by 70% from 14,400 to 4,500, according to Federal Deposit Insurance Corp. data. Having once controlled 95% of consumer and U.S. business dollars, banks now have less than 40% of that business measuring insured deposits against nonbank assets under management. According to a 2019 report by the FDIC, commercial banks’ share of the total lending market has shrunk to somewhere around 30% compared with a peak of 62% in 1974.

This means two things. First, the government is devoting nearly 100% of its prudential supervisory resources to regulate less than half of the financial risk in the system.

Second, the majority of Americans now get financial services from sources other than a bank as a new breed of fintech providers vie to replace the remaining traditional services provided by banks. When both changes in the financial products that are available and their delivery channels occur at the same time, convulsive economic dislocations are more likely than a gentle financial evolution.

Guard the economy’s gates

While every administration since President Clinton’s has studied the impact of technology on critical infrastructure, the fact is that not enough has been done to secure the economic infrastructure of the country against the malicious use of technology.

The deployment of technology to control the U.S. economy through the seizure of ATMs, manipulation of securities markets, or the appropriation of the Federal Reserve’s (or Treasury Department’s) transmission of payments is a temptation that some nations and fanatics may not be able to resist.

Consider just one area of concern. Whether based on encrypted-digital signatures or linked together in blockchains, today’s digital security in the form of public key cryptography may be susceptible to breach by quantum-enabled computers that could bring us closer to the “quantum apocalypse” described by scientists. While the National Security Agency’s goal of adopting quantum-resistant algorithms to replace current algorithmic security by 2024 is laudable, some scientists fear that algorithms may never prove to be quantum-proof.

Before the government gets intoxicated with technological happy talk and deploys crypto or central bank digital currencies, it should consider the future vulnerability of what it intends to build. We should first be creating a cyberspace financial defense command, a monetary coast guard and a payments systems’ early defense warning mechanism that can police digital traffic, and provide comprehensive economic protection, detection and remediation no matter where technology goes.

Create a smarter regulatory system

To prevent future financial crises, the regulatory system needs to be rebuilt in smarter ways and focus on the risks and concerns of the 2020s, rather than those that existed in the 1930s when it was created.

Enormous amounts of money are invested each day outside the banking business with the expectation that the larger the risk, the greater the return and the more likely there will be a bailout when that risk explodes. Rightly or wrongly, every financial crisis in this country since 1980 has been accompanied by such a bailout.

A regulatory system where 150 dueling federal and state regulators scrutinize every move each financial institution makes, while failing to appreciate the financial incentives created, will never be effective in today’s markets.

This tsunami of technological and financial changes represents the greatest economic policy challenges your administration will face in a post-pandemic world. Don’t rely on obsolete methods of oversight. And resist the temptations to use the financial system as a tool to implement social policy — that has usually ended badly for the least fortunate in the country.

I wish you success as your administration engages in this battle for global economic and technological superiority.

This article is drawn from Vartanian’s book “200 Years of American Financial Panics,” available April 2021.

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Joe Biden Financial regulations Fintech Fintech regulations Cyber security
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