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Todd Zywicki explains how the American banking system is regulated to the point where there is no room or even hope for innovation.

Zywicki starts off by simply explaining what a bank is and what it does. It is surprising how many people don’t actually know what their bank does for them. Early in life you are a borrower in order to buy a house or a car, later in life you become a lender to that same bank. Unfortunately, there has been so much regulation in the American banking system that there is no room for innovation which caused the phase out of mom & pop neighborhood banks.

What is a bank? What is Glass‐​Steagall? How much risk should banks take? How should a regulator address our bank system? What is a money‐​market fund? What is Dodd‐​Frank and did it get rid of bail outs?

Public Choice Concepts and Applications in Law (American Casebook Series), written by Maxwell Stearns and Todd Zywicki

The Law and Economics of Consumer Debt Collection and Its Regulation, written by Todd Zywicki

The Big, Fat Fed Has Diet Problems, written by George Selgin

“The Newsroom”: Season 1, Episode 6: Bullies, HBO Series

Further Reading:

The Specter of Wall Street, Free Thoughts Podcast

Going for Broke: Deficits, Debt, and the Entitlement Crisis, Free Thoughts Podcast

Is Bankruptcy Law Bankrupt?, written by William H. Meckling



00:07 Trevor Burrus: Welcome to Free Thoughts, I’m Trevor Burrus.

00:09 Aaron Ross Powell: And I’m Aaron Powell.

00:09 Trevor Burrus: Joining us today is Todd Zywicki, senior fellow at the Cato Institute and George Mason University Foundation Professor of Law at George Mason University School of Law. Welcome to Free Thoughts, Todd.

00:19 Todd Zywicki: Thanks guys, great to be here.

00:22 Trevor Burrus: So I’d like to start with a softball, but important question. And it’s somewhat related to what my dad does, which is banking law in Colorado, and he always complains and half of his job is explaining to legislators what banks are.


00:35 Trevor Burrus: ‘Cause they don’t seem to… They just wanna put all these regulations on them and he’s like, “Let me tell you what a bank is, right?” So, what is a bank and why are banks important?

00:45 Todd Zywicki: Well, banks, the amazing thing about banks is they’ve been around forever, and basically ever since they’ve been around, nobody’s understood what they did, but nobody likes it.


00:55 Trevor Burrus: Yeah.

00:56 Todd Zywicki: And here’s what I’ve learned about banking and I come at this from the perspective of, sort of the ordinary depositor and from the sense that I think in terms of consumer credit, which is, when you’re early in your lifespan you’re a borrower, right? Which is that you borrow money in order to buy a car, buy a house, get an education, furnish an apartment or whatever. Later in your life you’re a lender. And most people don’t think of that. And that’s an important concept, which is what banks do is convert deposit… Fundamentally convert deposits into lending. And most people don’t think of it that way, but the reason the bank pays you interest is because you’re making a loan to the bank.

01:42 Todd Zywicki: And so, when you’re older like I am in my 50s, I’m a lender now, right? I’m lending to the bank, the bank bumbles all those up and lends it out to people. They pay me interest, they charge even more interest than the loans that they make, but that’s why we have this whole apparatus end of deposit insurance and everything else. But that’s fundamentally all a bank is, is it takes loans from the public, bundles it up and lends it out to somebody else.

02:12 Todd Zywicki: And so they just basically convert deposits into lendable funds that come out the other side. And that’s the point that people don’t get, right? That’s what gives rise to all the questions about fractional reserve banking. Bank runs, bank failures, like we had at the bailouts and that sort of thing is. People intuitively think that the money in the bank is theirs, yet, they still wanna be paid interest on it. As if it’s a loan. And that’s what it is, is a short‐​term loan to the bank that the bank then converts into something else.

02:46 Aaron Ross Powell: Is that different, the bank as you’ve described, is that different from on the one hand, an investment bank, and then on the other hand, a credit union?

02:54 Todd Zywicki: Credit unions are fundamentally the same. The only difference with the credit union is, is that they’ve got special tax exempt status, they’ve got membership rules, but fundamentally, they do the same thing, they take their members’ money, pay interest on it, and turn around and lend it out to other people, they’re limited in what kinda loans they can make and that sort of thing. Investment banks are fundamentally different, in that investment banks are not collecting deposits. The investment banks basically, take investment capital and invest it in other projects.

03:30 Todd Zywicki: Ironically, there is an analogy in consumer finance to that also, which is something like a payday lender, for example. Payday lenders don’t take in deposits, basically, they take investment capital, some of it is money that they get from other people repaying their pay day loans, but they don’t take deposits, they just basically have money… People give them money, they invest it, if they’re a publicly held company, and then they lend it out to people and they try to make an operating profit. In that sense, they’re a mini version of an investment bank.

03:58 Trevor Burrus: One of the things that you hear every now and then, when it comes to investment banking versus consumer banking is Glass‐​Steagall.


04:06 Trevor Burrus: I remember an episode of Aaron Sorkin’s Newsroom, where one character says that, “With Glass‐​Steagall, we won a World War, we put men on the moon and we created the greatest consumer economy, and then tried to blame it all on Glass‐​Steagall.” What is Glass‐​Steagall, and why are some people so obsessed about it?

04:22 Todd Zywicki: Glass‐​Steagall, without getting in too much of the details, Glass‐​Steagall created this so‐​called wall between investment banks and depository institutions. What I was describing earlier was a depository institution, where you take consumer deposits and convert it into lend‐​able capital. And a Glass‐​Steagall had this sort of… But the logic of Glass‐​Steagall is essentially that you can protect the depository banking system from risk. And it singled out a particular type of risk, which they thought was risk that should be called investment banking, but that’s just one type of risk, right? So, for example, the S&L crisis of the ‘80s.

05:13 Trevor Burrus: You know, Glass‐​Steagall is [chuckle] around for that, right? Lending inherently has risk and to sort of say, this particular risk is something that should be outside the banking system, and even crazier risk, which is basically what an S&L was. Let’s take short‐​term deposits and then make 30‐​year loans, right. That is somehow considered safe. And it was allowed by a Glass‐​Steagall type mentality. And so, I think the mythology of Glass‐​Steagall is much more… And what it did is, I think much more relevant than the reality.

05:53 Trevor Burrus: So it was repealed in the late ‘90s, correct?

05:54 Todd Zywicki: It was repealed in the late ‘90s, yeah, when President Clinton was President. And I think it was repealed for good reason, which is this sort of kind of arbitrary idea that we can create a risk‐​free banking system, or that we can really create a risk‐​free financial system, I think is probably a more accurate way of trying to figure it out, where the risk just goes elsewhere in the system and it was repealed in the ‘90s. I don’t think anybody… It’s got a lot of mythology, but I have yet to see anybody explain to me how the repeal of Glass‐​Steagall meaningfully influenced the 2008 Financial Crisis. And a lot of people point it to the fact that the financial crisis… Crowns, really the financial crisis was traditional banks. It wasn’t investment banks that were the problems, it’s traditional banks and the mortgages that they were writing, and the old thrift institutions like Wachovia that were the inheritors of the old S&Ls.

06:55 Trevor Burrus: When you talk about risk, it makes me think about another thing I think a lot of people think about banks, and investment financial services in general, is that these businesses are incentivized or want to be really risky, that we got… I think after the financial crisis, we have this idea that Wall Street people are… Got their foot on the gas, and that what they really wanna do is be extremely risky with your money and possibly impoverish you. But that seems to me like not a good business plan.


07:22 Trevor Burrus: Just as I would say. I mean, there are definitely people who like to go out there and maybe risk a lot to make a big reward, but in general, is there a lot of incentive to be really risky in the financial system?

07:33 Todd Zywicki: Well, if you create a system where you privatize the gains and socialize the losses. [chuckle]

[overlapping conversation]

07:40 Trevor Burrus: Well, that’s not risky though, ’cause then you’re socialized.

07:42 Todd Zywicki: Yeah, you get what you pay for. And so, that’s basically what we did, was we allowed them to keep their gains and then when these risks went belly‐​up, we bailed them out and that was that. So obviously, the key is you’ve gotta align the… You’ve gotta get the incentives right. The way… And we have a very messy, goofy history of financial regulation in the United States. For the longest time, for all kinds of political reasons we had, we didn’t even allow branch banking and then we allowed branch banking within states, and now we allow full branch banking, interstate banking and that sort of thing.

08:25 Todd Zywicki: But you know, one of the reasons the Great Depression was such a fiasco was because we got these little mom‐​and‐​pop banks, essentially, these little… Who would hold some farm loans, and that’s basically their whole balance sheet. And people kinda figured out that wasn’t a good idea, that wasn’t gonna help stabilize the financial system. And so over time we’ve kind of overcome some of those political hurdles, but a lot of that is still in kinda the country’s DNA, this distrust of banks and the idea that people don’t really understand what banks do, and so we gotta regulate them, we gotta keep them from taking risk and that sort of thing.

09:03 Todd Zywicki: Whereas, I think to your point is, there’s some… Unless banks can externalize their risk‐​taking on the rest of us, there’s no reason for them to come up with a model that’s doomed to cause them to blow up. It’s only when you create a world in which… Where you privatize the gains to socialize the losses that you could get anything that looks like excessive risk taking.

09:27 Aaron Ross Powell: On this quantifying risk or like me as a consumer, so if I go and I’m gonna buy a stock, I kinda know conceptually that the stock market is somewhat risky, and I can get when I go to buy the stock, I can see, here’s the chart of how it’s done over the years. And the problem of induction aside, that I can see if it’s, seems to be pretty steady or it’s been all over the place, or whatever. But when I go and open a savings account at my local bank that’s not the kind of information they give me. They don’t tell me like, “Here’s the kind of investments we’re making, and here’s how many have defaulted,” and all that. And so, is there a need for regulation to either protect me, ’cause they could… What this means is, they could be much more risky than I would be willing to invest with if I knew, and so either to protect me or to make sure that I have better information about the kind of risk that I’m entering into?

10:23 Todd Zywicki: Yeah, Aaron, I mean, this is a great question, right? And this is… When I think about financial regulation, this is the issue that I wanna say keeps me awake at night. But the issue I can’t figure out the easy solution to, which is the following. Which is, we said at the outset, the reason the bank pays me interest on my savings account is because I’m lending it to the bank, and the bank is turning it around and making profit with it. And so, they pay back some to me, say 1%, they lend it out at 4%, they make a 3% return, I get 1%. That’s the logic, right?

11:04 Todd Zywicki: But the reality is, I’m lending them the money and it’s only because they can take it and convert it and put it in something that has risk, that I get back. Now, given that the world in which I have to monitor with my $12,000 in the bank, am I really supposed to monitor what the bank is going to do with it? That makes no sense at all for individuals. This is the logic, right, is, you’ve got huge free riding problems where people would free ride, you’ve had information problems and it just doesn’t make sense that that’s how… That all of us is… Hundreds of millions of individual depositors should be monitoring what the banks do with it. So, what do we end up do… And then, you’ve got that and then you have…

11:55 Todd Zywicki: You actually do have the bank run phenomenon, where a solvent bank could have the bank run simply because they aren’t liquid enough the day that all depositors show up, and all depositors show up and demand their money. So, this is where… Then we get deposit insurance. Deposit insurance is designed so that to save me the cost of having to monitor my investments in the bank. But as soon as you have the deposit insurance, you have exactly what Trevor and I were just talking about, which is now you have the bank playing with the taxpayers money, that creates then the potential for the bank to engage in overly risky behavior.

12:35 Todd Zywicki: So then what do you have? Then you have to say, “Well, we have to have regulation and inspect the banks,” in order to make sure that we aren’t having what’s called the “moral hazard problem”, if the bank basically acting recklessly because it’s not their money, it’s the taxpayers money. And so, in some sense, it’s not completely accurate, but sort of the original sin that leads to the whole apparatus of banking regulation is deposit insurance. But the problem is, nobody has been able to come up with a really compelling…

13:11 Todd Zywicki: There’s a lot of theories and a lot of people in this building who have great ideas, but in terms of actually winning the war on ideas and explaining to people why they’ve got a better mouse trap, nobody’s really been able to come up with a system that they’ve been able to explain to people is better than deposit insurance. But as soon as you buy the premise and some such you buy the bid, and this whole cascade of regulation then tends to flow from this little kernel of deposit insurance.

13:38 Aaron Ross Powell: You said though that the problem here is, suddenly once they’ve got the deposit insurance, then they’re playing with the taxpayers money.

13:44 Todd Zywicki: Right.

13:44 Aaron Ross Powell: But why wouldn’t it just be that if I invest in a bank, and then that bank makes risky decisions and so loses all of it, the insurance is insurance for me, so the government pays me back what I lost. But that bank still goes bankrupt or that bank could still be on hook for say reimbursing the government for it, so they’re not getting to kinda play with free money.

14:07 Todd Zywicki: Yeah, I mean, I was kind of over simplifying the point, but it’s not the bank’s money, right? The bank isn’t gonna be the one who’s gonna pay me back, they’re not a real borrower in that sense. It’s not like lending money to Walmart or somebody, where… Or Kmart. I mean, look at Kmart and Sears. I mean, where ordinary people had stock or maybe even had bonds that went belly up and they got paid pennies on the dollar, that doesn’t happen when it’s a bank, as opposed to some other business.

14:43 Trevor Burrus: Do we really need to have consumers know or require that they know that much or monitor their $12,000 bank account. Because if I compared it to something like food production, the Romaine lettuce scare of recent, right?


14:56 Todd Zywicki: Right.

14:57 Trevor Burrus: I mean, I… Obviously, I think anyone who understands market forces, that Chipotle’s scare, it had its healthcare scare, made Chipotle extremely conscious of how clean its food was, much more than any government regulator could possibly do. And any company that produces Romaine that gets an E. Coli scare is gonna really try and climb out of there, they’re gonna go out of business. Now, that doesn’t require their consumers to know where the Romaine lettuce comes from and monitor all these things that they don’t know, they just look at companies that have a reputation on the line to go out of business if they get such a food scare. Is that not enough for banks that Bank of America simply is not going to in, under most circumstances play fast and loose with my money and I don’t actually have to monitor them at all, I just have to know that they care about their self‐​interest?

15:43 Todd Zywicki: Yeah, I mean… And I wanna make it clear, is I’m not advocating for deposit insurance, right? What I’m saying is that there’s. There is in fact an identifiable problem, and a lot of people have come up with solutions, including things like name brands and all the things that you point to, Trevor. You could have private insurance, I think probably is something that could make sense, where somebody was writing private deposit insurance. All I’m saying is that that it is actually a very vexing problem and that people haven’t really come up with a generally accepted response. And so, George Selgin, for example, my colleague here now is one of the all‐​time leading experts on free banking, right?

16:32 Trevor Burrus: Yeah.

16:32 Todd Zywicki: And he can explain this to you and he can explain how deposit insurance works. And a lot of it had to do with name brands and it had to do with, the people around the bank had their own skin in the game. You could create those kinda systems. And I think there’s a lot of sense to it, and people just haven’t quite gravitated towards that. You could come up with a lot of solutions, I think. And so I don’t want to say that that’s the only solution, but that’s kind of what the…

16:57 Aaron Ross Powell: Inherent problem is.

16:58 Trevor Burrus: Yeah, what the inherent problem is. There’s a second problem that I’ve been fascinated with for a while, I wrote an essay a few years ago called, Making the Banking System Antifragile. And it was a book review of Taleb’s book on antifragility. And what I point out there is that when we talk about risk and this goes back to your question, Aaron is, there’s actually two concepts of risk in the financial system, which is, there is the risk of a particular bank failing and there’s the risk… Systemic risk of the banking system. And what are kinda command and control central planning version of regulation we have today is just focused on the former, which is the individual bank, and they wanna keep individual banks from failing.

17:42 Todd Zywicki: And so, what they basically do is dictate sort of the platonic form of the perfect bank balance sheet, right. And that’ll be the world’s safest bank, right? The problem is, that what they’ve ended up doing is making every bank look the same. So if they’re off a little bit on one bank, then they’re off a lot when it comes to thousands of banks. And so, I think in terms of trying to make individual banks less risky, it’s possible we made the banking system more risky. And it may be that if we allowed for more trial and error, more experimentation at the individual bank level, we might actually have a more stable systemic banking system, which I don’t think people think about. The other half of that is you can prevent bank failures beforehand, or we could focus more on mitigating the fall out from bank failures after the fact, right? There’s a… And instead, we’ve kinda got a cookie‐​cutter model that we’ve had for almost 100 years now, of how we think you’re supposed to regulate banks and this is hard to believe, but yet, again and again we keep having banking crisis.


19:00 Aaron Ross Powell: How does or how ought a regulator to approach these kinds of questions? Because what you’re saying is, we don’t… There are different things that we need to weigh, there are different kinds of risks. There are different ways we might approach it, some might work, some might not, a lot of them are susceptible to shocks that are unpredictable. And the regulator is sitting back and saying, “Okay, I’ve gotta do something,” even if that’s like deciding to deregulate, they’ve gotta do something. And they’re doing this all with people’s savings. And so, it’s hard to run… You don’t wanna run experiments in here, because the costs for failure are very, the individualized cost for failure are very high. So, how do you… I mean, not necessarily how do you answer these questions, but how do you approach thinking about these questions from the perspective of someone who has to then make decisions about them?

19:54 Todd Zywicki: Yeah, and the real problem here, it’s not just what should they do, but what do they actually do? So, one of the classes I teach and one of the course books that I have is on Public Choice Economics, that’s where I feel that I’ve worked a lot. And one of the things we know from Public Choice is that, bureaucrats respond to incentives just like everybody else does. And so, one of the impacts of that is, is that what a bureaucrat’s personal incentives are may not be aligned with the overall job he’s supposed to do, what we call “agency cost”.

20:29 Todd Zywicki: So, a good example is the FDA. And the FDA constantly gets criticized over time, because drugs are… Take too long to approve, and are too expensive to approve. And the reason is, is because from the perspective of the individual FDA person, they get very little credit if a drug is approved and a lot of blame if a drug turns out to be dangerous. And my colleague here, John Allison, former President of Cato, obviously and a fellow of my… A colleague of mine here in the financial markets group said this happened in the financial crisis, after the financial crisis with the bailout money, the tarp money. Banks are supposed to lend that out, but individual bank examiners out in the field at the First Bank of Omaha, or whatever were basically saying, “Heck no, you’re not making any risky loans, because my job is… ”

21:19 Trevor Burrus: “Well, I’m not doing this again.”

21:20 Todd Zywicki: Yeah, “My job is to keep this bank from failing, not to try to save the American economy.” But if you have every single bank examiner with that risk‐​averse incentive, because they didn’t get credit if the bank was gonna make marginally riskier loans that might help the economy, they get a lot of blame if it failed. And so, I think that’s a lot of what the problem here is, is that you have to have somebody who has the ability and the willingness to look at it from the whole system. The kind of things we’re talking about, to think in terms of, what is the optimal… Or is there… So what is the optimal rate of bank failures that is…

22:03 Trevor Burrus: Which is not zero.

22:04 Todd Zywicki: Which is not zero that’s consistent with the overall, preserving the overall stability of the banking system. But we also have it for individual consumers. One of the things that happened during the financial crisis was, money market funds. Every time you open a money market fund, what does it say? “This is not FDIC insured.” But what happened was, because it wasn’t FDIC insured, it was a little riskier, banks will give you a little more yield for it, and they’d say, “Well, it’s just as good as the savings account,” right? And it turns out it was just as good as the savings account.


22:38 Todd Zywicki: ‘Cause when the rubber hit the road and the banks went down…

22:40 Trevor Burrus: They bailed them out.

22:41 Todd Zywicki: They bailed them out, and they treated money market funds just as if they were savings accounts. And so, you’ve always got a frontier, there’s always a margin between… As soon as you put in things like insurance and stuff like that, there’s always some margin there where people could get a little more yield and they think, “Well, it’s not that much more risk.” But then… And sometimes you come to self‐​fulfilling cycle, I think.

23:06 Trevor Burrus: So our last major financial law, which I think we’re still passing regs under if I’m correct, is Dodd‐​Frank, which was passed in the wake of the financial crisis. And it occurs to me that the financial… The history of our financial system is kind of this crisis, and leviathan story where Bob Higgs’ book has been on free thoughts, where he discusses war and war powers, there’s a crisis and then someday you get an increase in government regulation. So we had a crisis, so we passed this huge law called Dodd‐​Frank. What in general did Dodd‐​Frank do or purport to do to solve the problem or make it worse, either one, your choice?

23:42 Todd Zywicki: Well, first I want to endorse your comparison to Bob Higgs. And in fact, one of the things I’ve been fighting against the last 10 years is, there are people who… And particularly Jim [23:54] ____ and Eric Posner, two law professors who’ve drawn a direct comparison between the War on Terror in 2001 and the Financial Crisis in 2008, and have called for basically saying that that show’s why we need to be able to unleash executive discretion and throw the rule of law overboard in times of crisis.

24:15 Trevor Burrus: ‘Cause that never goes wrong, right?

24:16 Todd Zywicki: Yeah, right, exactly. But they’ve drawn exactly that same parallel and that’s exactly what happened was, as a result of the financial crisis the banks got billions and billions, tens of billions of dollars, but they’re gonna be paying it off, and paying for a very long time, which is that what it did was, it allowed the politicians and the regulators to get their hooks even more into the banks than they had been previously. And they got a pretty good argument, we gave you $700 billion, and we wanna make sure it doesn’t happen again. But what they’ve done since then, isn’t just that, I mean, Dodd‐​Frank is a lot more than that, and the way the regulators had implemented it was a lot more than that, particularly under the Obama administration, with Operation Choke Point and various various other things.

25:11 Todd Zywicki: And Dodd‐​Frank itself had a lot of things were just kind of a wish list for people that have been around for a long time, the Durbin Amendment, things like that. Here’s what’s fascinating to me about Dodd‐​Frank. I’ve spent the last 10 years touring the country, lecturing to… On college campuses and law schools and to Federalist Society lawyers chapters and other lectures and that sort of thing. And every time I lecture on Dodd‐​Frank, I at some point ask… Congressional staffers I’ve asked, so I say, “How many… Dodd‐​Frank was supposed to do one thing, which was what? Get rid of bailouts. Dodd‐​Frank said we’re getting rid of bailouts, and we’re getting rid of too big to fail.” I’ll tell you guys, as I’ve traveled the country, I have asked that question to literally thousands of people and one person, this smart alec kid at West Virginia University in the back corner raised his hand.


26:07 Todd Zywicki: I’ve asked the congressional staffers, everybody… I say, “How many of you think Dodd‐​Frank got rid of bailouts and we’re never bailing out another bank?” Nobody believes it. People, voters don’t believe it, markets don’t believe it. The too big to fail subsidy still seems to be there. We passed 2400 pages of legislation, tens and thousands of pages of regulation, tens or hundreds of billions of dollars in compliance costs, and Dodd‐​Frank did not do the one thing it was supposed to do. If you wanna know Dodd‐​Frank in a nutshell, that’s it.

26:42 Aaron Ross Powell: So how was Dodd‐​Frank supposed to do that? How was it supposed to end bailouts and too big to fail?

26:48 Todd Zywicki: Yeah, well, the logic of Dodd‐​Frank was two‐​fold, which was, we’re gonna come up with a better system of regulation that will prevent bank failures on the front end, and we would guarantee the banks will never be bailed out on the backend. Then they came up with this sort of convoluted process on the backend, of putting banks into what amounted to a receivership and guaranteeing that they would be liquidated. On the front end, we would have this whole system of SIFI, systemically important financial institution, so it would be subject to particular intensive regulation. We’d have stress tests, we would have the Volcker Rule, which would get rid of… Supposed to get rid of the risk that was in the system.

27:35 Todd Zywicki: So all these things on the front end that we’re supposed to control risk and then on the backend, basically the idea is, is “We’re gonna make sure we never bail you out, we’re gonna make sure you get liquidated,” essentially is what it is. And one of the things that’s interesting about that, that shows how politics work is David Skeel in his excellent book on Dodd‐​Frank, he notes that nobody really… The idea that they came up with for getting rid of bailouts, was nobody… They just kinda Jimmied it up. And it’s not clear it would work or what, but one of the points he makes is very interesting, is for non‐​depository institutions, for example, most people think a bankruptcy system is actually the best way to do it. And it turns out if you actually look at the Lehman bankruptcy, it worked out pretty well, even though it was messy at first.

28:28 Trevor Burrus: We have hundreds of years of bankruptcy law [28:30] ____ this stuff.

[overlapping conversation]

28:31 Todd Zywicki: [28:31] ____ bankruptcy law, the rule of law operates. So why didn’t they consider bankruptcy option? Well, it’s because Dodd and Frank wanted to write the law. Bankruptcy is under the jurisdiction of the Judiciary Committee.


28:44 Todd Zywicki: Dodd and Frank are in the banking of Financial Services Committee. So basically, they started with the premise, “We’re writing the law. Now let’s figure out if we can reverse engineer some system that would do.” So they never even consider what most people think would be the best option. But that was the idea, and the idea isn’t so much did the system in theory, couldn’t work? Some people I respect say it would work. The problem is, nobody believes that it will actually be tried right, which is… It was passed on a party line vote pretty much with no Republican support that’s completely untried system by the Democrats and nobody I talk to thinks that if the banking system goes into crisis that the secretary of treasury, is gonna walk into President Trump’s office and say, “All right,” the oval office, “Mr. President, there’s this completely made‐​up system that the Democrats put in place 10 years ago. It’s never been tried before. It might work, but let’s bet the economy on it.”

29:48 Todd Zywicki: And nobody’s believes that’s gonna happen, right? They don’t have the political will for it, they don’t have the way of doing it. And so what you’ve created is a system in which banks rationally expect to be bailed out, markets rationally expect banks to be bailed out, and once you have that expectation, it becomes self‐​fulfilling. And in the end, that’s what Hank Paulson said when he was secretary of the Treasury, “We’re bailing out the banks because the markets expect us to bail out the banks.”

30:17 Trevor Burrus: Seems like a self‐​fulfilling prophecy.

30:20 Todd Zywicki: It’s exactly a self‐​fulfilling prophecy, which is the expectations become self‐​fulfilling. And so what we talk about this in economics, and so we call the need for credible commitment. Which is, it’s gotta be a credible commitment that you will actually not bail out the banks and nobody believes that. And that’s the problem. It’s a political problem, not a legal or economic problem, really.

30:42 Trevor Burrus: It seems like the designation of certain institutions as systemically important financial institutions is basically a list of who they will bail out. That, if they’re gonna be… If you got that status, I don’t know if you get a badge or a sign you can hang on your door or something, but you pretty much are signaling that we’re probably gonna be bailed out and other ones aren’t going to be bailed out. Does the market reflect that?

31:03 Todd Zywicki: That’s how the market treats it, yes. And so what they talk about is what’s called a too big to fail subsidy, which is those banks can access capital markets and raise money and capital markets more cheaply than banks that don’t have that badge, right. There’s cost that go along with it, but there’s a…

31:27 Trevor Burrus: Compliance cost regulatory.

31:28 Todd Zywicki: Yeah, higher compliance cost and that sort of thing, but it looks like for those banks, the benefits exceed the cost in light of what their returns on capital have been and their ability to continue growing relative to other rivals.

31:44 Aaron Ross Powell: It would seem then that we would… So a lot of the same people who seem to be very pro‐​banking regulation are very anti‐​monopoly, they love antitrust. And this seems like what you just described would be exactly the kind of thing that would upset them because if this subsidy kind of exists, it not only may prop these people up or encourage them to be more risky, but it’s gonna make it awfully hard for people new entrance in the market to compete with the ones that have been designated. So is that a worry? Should it be a worry?

32:11 Todd Zywicki: That’s the great irony of all of this, Aaron, is that what Dodd-Frank’s great legacy is, and it’s going to be, is to make too big to fail institutions even bigger and more important, and drive smaller institutions out of business. Every industry that Dodd‐​Frank has touched, from debt collection to mortgages to banks, have had this effect. And it’s for two reasons. And so what we see is the largest banks keep getting larger and increasing in their market share, and smaller banks, estimates vary, but have been shrinking at about twice the size of what it was before Dodd‐​Frank.

32:56 Todd Zywicki: And that’s for two reasons. The first is the too big to fail subsidy, which just gets converted into lower cost of capital. The second is the cost of regulation, which is most regulation has the impact that it does not scale, in banking regulation [33:11] ____ ’cause it doesn’t scale proportionally to size, so it’s not a linear function. Which is to say, the small banks spend a higher percentage of their revenue on compliance with regulation than large banks. For City Bank 150 new compliance officers of the rounding error, right. For some small community bank with 10 employees, hiring one more compliance officer, could be the difference between a profit and a loss, right? And it has to do with there aren’t that many more forms to fill out, you can get economies of scale and all that sort of thing. And so what that’s done is that regulatory cost them the small banks is driven a lot of them out of business.

33:54 Todd Zywicki: Congress finally passed a regulatory relief build this spring that was designed to address that and addresses it in kind of a little bit haphazard fashion, the way they did it. And so we’ll see whether or not that has an impact, but so far, Dodd-Frank’s great legacy has been to consolidate the industry and there is a great irony there of course which is that the small banks who didn’t cause the crisis are the ones who are getting hit the hardest, and those who supported the legislation of implicitly basically been making the big banks bigger and more powerful.

34:31 Trevor Burrus: Well, then we get the kind of double way I mean where so much of the free market theory on banking in the, where we say we don’t necessarily need regulation is because we have competition. But that would also lower competition. And so then if we only have four banks or whatever and they all know everyone on that on the hill, and we don’t have competition anymore, so now we need regulation so our system doesn’t work and then someone comes to free marketers and says, “Look this free market system doesn’t work because they need more regulation,” or like, “We left the free market system about 40 years ago.” And that’s what again, my data has said, that he represents community banks, and he said he doesn’t think there’ll be almost any community banks in 15 years.

35:12 Aaron Ross Powell: That’s a problem that we libertarians and free marketers face and basically everywhere.

35:15 Trevor Burrus: Of course, pretty much everywhere. [chuckle]

35:17 Aaron Ross Powell: Everyone’s like, they just point out like, “Oh, free market didn’t work.” And it’s like that’s not even close to a free market.

35:21 Trevor Burrus: Well he said, he… Something my dad had pointed out, is we might get to the point where you have to pay the bank to take your deposit. Which is really bizarre, it flips the entire system on its head, where the bank should be paying you and the interest rate or something for you giving them your money but if the regulations are so high you might actually have to pay the bank to take your deposit. And that’s like some tipping point almost world’s flipped around on its head.

35:44 Todd Zywicki: Well, implicitly, that’s actually happened. Trevor mainly because of the Durbin Amendment. The Durbin Amendment place price control on debit cards cutting Debit Card for large banks in half. The response that was, is that the revenues that have been generated for consumer accounts through debit card usage are interchange fees, and that’s the fee that gets paid to your bank, when you swipe your card, to Target or something like that, say, one or 2%. To make up for that revenue shortfall. What did they do? They just started imposing cost fees on account holders.

36:21 Todd Zywicki: Now, upper middle class people, middle class, upper middle class people, we didn’t really notice it, right? All we had to do is increase our average monthly balance and we continue to get free checking, we tend to consume other products from the bank, whether a mortgage or a car loan, or whatever. But low income people, all of a sudden were having to pay $10–15 a month for a bank account. So free checking went from 76% of banking counts to 38% of banking counts in the period after the Durbin Amendment. The average monthly fee for those who did not have free checking doubled during that period.

36:56 Todd Zywicki: That’s equivalent to basically having to pay the bank to take your money. And what that really fell hardest on, was lower income consumers. And that’s one of the other things that happened in the wake of the financial crisis was between the Durbin Amendment which took way free checking, the Credit Card Act, which was a rule that a legislation that interfered with the ability of credit card issuers to be able to just prices when risk changed between the regulations on mortgages. What we end up doing was taking away from low‐​income consumers, we took away their bank accounts, we took away their credit cards, we took away mortgages. And so what we ended up doing was basically taking low‐​income consumers and driving them out of the mainstream financial system, and as a result, payday lenders boomed.

37:45 Todd Zywicki: And of course, the way Washington works is because all these people were turning to payday lenders, that meant we had to get rid of payday loans.


37:54 Todd Zywicki: And which is essentially what they ended up doing, they tried to do it to The Consumer Financial Protection Bureau, though looks like it’ll be undone.

38:02 Aaron Ross Powell: This notion though of paying, the consumer paying the bank instead of earning interest. In the abstract so I have a checking and savings account with my bank. I also don’t have any loans from that bank. So the services that I’m using is the reason I put my money in there, because they’re giving me interest but it’s some vanishing‐​ly small amount.

38:20 Todd Zywicki: Right.

38:20 Aaron Ross Powell: Right. It’s convenient for me to have my money there because then I can withdraw it from ATMs. I don’t have to carry it around in my pocket, I can use my debit card to buy things so on and so forth. It’s probably safer there than it would be under my mattress, and all of the other reasons that we wouldn’t wanna use cash. And those all seemed like those are valuable services provided to me. So, outside of the specific instances like certain people would have a harder time of getting loans or whatever, would it be bad if part or large portion of kind of the consumer banking industry shifted to a model where I was basically just paying my bank a small monthly fee for the service of giving me these things?

39:00 Todd Zywicki: You could have that, but here’s my view. It’s two‐​fold, which is, first, financial inclusion is a stepping stone to people’s success in life. I believe financial inclusion is a moral imperative, which is to create a… Where people can basically get integrated in the financial system, to be able to buy a car, to be able to get a credit card, to have a bank account. That is a springboard to a lot of other things in your life, to basically live from a financial perspective, economics of the American dream. And so if you force consumers to pay for a bank account, that makes it more expensive for people to do that. And maybe it’s optimal to do that, but I think that there’s a lot of benefit to consumers from having access to financial services.

39:58 Todd Zywicki: Having said that, I am frustrated. I think the American commercial banking system is incredibly non‐​innovative. I think partly that’s caused by regulation, I think partly it’s because of this kind of system we’ve created where the government basically protects them from competition by telling them they’re not gonna have to worry about failure. So, why innovate if you don’t have to? But I think that what we need is a greater array of banking products, more things that are accessible, like online banking platforms, things that are… Right now we, basically they put you in the unbanked bucket or the full bells and whistles bank account bucket.

40:41 Todd Zywicki: A lot of people don’t need those two extremes, they just need to be, have some way to be able to pay bills, especially younger people, and maybe they transcend into something more formal. And I think that we need more innovation in the system, I think. I’m a big promoter of FinTech potentially, you know things like that, that can get financial products to people who have been traditionally outside the system.

41:10 Trevor Burrus: Has… This is something else you hear about banks quite often, and Wall Street in general, which of course is this giant group of people that we lump in together, investors and traders and banks and everything, but has Wall Street captured the government?

41:25 Todd Zywicki: I don’t know if I would say that. And there’s kind of a mutual sort of thing going on there. So I’ve written about this in some of my articles. One of the classes… You know, we distinguish between two concepts in public choices, there’s the rent‐​seeking where the interest group goes to the government and asks for a favor, rent extraction, where the politician goes to the industry and basically threatens to harm them unless they give them money to buy them off. And there was a famous story that Tim Carney reported right after, when Dodd‐​Frank was being written, when Senator Schumer went up the Wall Street. And prior to Dodd‐​Frank, hedge funds had largely stayed outside of the political process, they weren’t that involved.

42:14 Todd Zywicki: And Chuck Schumer, Senator Schumer, went up to the hedge funds, called them all together in New York and basically said, “Look guys, you’ve got a lot of money, and none of it’s appearing in Washington, and you know and I know that hedge funds didn’t cause the financial crisis, but the American public doesn’t know that. We’re thinking maybe it’s time to maybe slap some regulations on hedge funds, unless you can persuade us not to, right?” And they came up with several million reasons why they should not include hedge funds in Dodd‐​Frank, and largely that was successful. But…

42:49 Aaron Ross Powell: Well quick, when you say they came up with several million reasons you don’t mean that they paid a politician…

42:54 Todd Zywicki: What I mean is that…

42:55 Aaron Ross Powell: Millions of dollars to go away?

42:57 Trevor Burrus: Campaign finance, campaign…

42:57 Todd Zywicki: What I mean is… Yeah, that there were massive investments by hedge funds in the Democratic Party and in political campaigns and lobbying efforts, and the like. So I was being a bit tongue in cheek. But basically what happened was they went from being non‐​players in Washington to being millions of dollars in every electoral cycle players, and what they got out of it was that the federal government did not pass ruinous regulations on them, which was what the threat was. That’s what we call “rent extraction”. And so we have this entanglement, and I think we see the same thing in the banking system, which is that in exchange for the bail out money, in exchange for their protection, the government especially during the Obama administration sort of used the banks to as an off‐​balance sheet sort of social policy thing, whether goes back to the Community Reinvestment Act, which my colleague here, Diego, wrote a great piece this week talking about the Community Reinvestment Act in the American Banker.

44:04 Todd Zywicki: Or whether it was various things that the CFPB did, or various other things that bank regulators do, where they basically used banks to accomplish social policies, more or less in exchange for protecting them from competition and failure. And that’s, whether it’s Wall Street or banks, that’s kind of the kinda crony capitalism system we have with this heavily regulated system where the rule of law is really not present in any shape or form in our financial regulatory system. It’s all back room deals and non‐​transparent according to very flexible standards, and a lot of it is who’s got the best lobbyist to be able to protect themselves.

44:51 Trevor Burrus: So we look at the theme, I think of this conversation. We’re talking about the FDIC deposit insurance kinda changing the risk function for banks and then trying to monitor what’s going on and then stacking it on top of that, and crises occur, and all this stuff. It seems to me that if we don’t increase competition in banking, we will have to, if we look backwards, we will have to increase regulation if we continue to incentivize risky investments, or putting money into places that are less sure things. If that goes up, we will end up with state banking or things like this. How do we actually roll this back, how do we increase competition? Because we have so little of it now, that we need more regulation. But is there any way out of this sort of mired pit?

45:38 Todd Zywicki: Well, the idea of State Banking, of course is not completely hypothetical. One of Senator Elizabeth Warren’s pet projects the last few years, is post office banking. I don’t know if you’re familiar with that, where the post offices would turn into banks taking deposits and making small dollar loans and that sort of thing. And so there’s actually proposals for, that are along those lines. And on a more attenuated basis, there’s been long standing proposals for a century now to basically treat banking, like a utility and regulated like a utility, right? I think that grossly misses the point on the art of underwriting and risk assessment and all that, that sort of stuff, but it is, it goes back to misses and the dynamics of intervention, which is once you start down this path and once you start with deposit insurance, which is kind of the original sin, to some extent the rest kind of makes sense, right?

46:41 Todd Zywicki: Not the abusive stuff, where you start using the banks basically to promote your own pet projects, or Operation Choke Point, where during the Obama administration, the FDIC tried to shut off bank accounts to legal businesses like payday lenders. I mean that stuff just bad news. But a lot of the regulation kind of flows from that one simple idea in the economics of it. And so, how do you…

47:07 Trevor Burrus: It’s there was an old woman who swallowed a fly, problem.

47:10 Todd Zywicki: Yeah, it’s…

47:10 Trevor Burrus: ‘Cause if you swallow a spider and then you swallow the cat and then…

47:13 Todd Zywicki: And it’s banking and it’s healthcare and it’s higher education. Neal McCluskey here, the Director of Education Studies and I have a book coming out at the end of January on trying to introduce competition and consumer choice into the higher education system, is a system for reform. But all these areas, once you get the government in there, and once you break the incentives, the problem with higher education is finance, federal financial aid. And federal financial grants, which break the lock, the link between what I pay for and what I get. Now you’ve basically created a third‐​party payer system, which then leads to making sure that the universities are credible, which leads to accreditation which drives up costs.

48:00 Todd Zywicki: Which creates cartels which dampens competition, right? Every time you start down that one step down there, you really do get missuses dynamic of interventionism, or each intervention creates on attended consequences, which then need to be addressed, which create new unintended consequences and that sort of summarize it. Jeb Hensarling, who’s retiring now, was Chairman of the House Financial Services Committee, he was ranking minority member I think at the, when Dodd Frank was passed and he said, I remember his speech on the floor of the House was, I think he said, “This legislation,” the form he had, “is 900 pages long, and there’s at least three unintended consequences on every page of this legislation.”

48:46 Todd Zywicki: Somewhere in Dodd‐​Frank is the next financial crisis. We know that. We know that there’s something in Dodd‐​Frank that’s gonna create some sort of quirk that’s gonna end up spawning the next financial crisis, and then we’re gonna have a whole new slate of regulations to deal with that, which create their own unintended consequences in the next financial crisis. That’s just the dynamic and more complicated regulation, more discretionary regulation, just doesn’t seem to solve these problems. I think that what we really need to think in terms of is going back to the rule of law. Going back to getting the basics right, understanding the rule of law, putting liability in the right place, and kind of work within those principles rather than creating unintended consequences and rushing to address those with more complex regulation that creates more uncertainty in, you know, the next problem.


49:46 Aaron Ross Powell: Thanks for listening. Free Thoughts is produced by Tess Terrible. If you enjoyed today’s show, please rate and review us on iTunes, and if you’d like to learn more about libertarianism, find us on the web at www​.lib​er​tar​i​an​ism​.org.