Just beyond the present horizon, shrouded by our collective focus on price inflation, the economy faces the specter of another crisis—one many presume we’ve put beyond reach.

In the wake of the Great Recession, Congress passed, and President Obama signed, legislation explicitly designed to protect against a repeat of the financial shenanigans that prompted the 2007 meltdown. Voters were broadly disgusted and angry when Washington offered bailouts to Wall Street while Main Street businesses were left to suffer. And so Democrats, having wrested simultaneous control of Congress and the White House for the first time since 1994, mobilized to pass Dodd-Frank, a financial reform package crafted both to make sure banks never again got so far over their skis and that Washington wouldn’t have to come to the aid of what Congress believed were flat-out imprudent lenders.

For years, many grumbled that the law was riddled with loopholes. But now, little more than a decade later, Dodd-Frank’s shortcoming are poised to come into clear view. It’s not that the regulations born from that now decade-old law were too lax—in fact, the nation’s banks today are subject to very strict scrutiny. Rather, it’s the world of finance outside the more proscribed banking community that is stirring up a witch’s brew.

What some call “nonbank” financial firms—money managers, student lenders, mortgage companies, auto lenders, consumer lenders, hedge funds, private capital firms, internet-only banks and various other asset management and payment firms—offer many of same services banks offer, but are not required to maintain the same government license. As such, they’ve been given the okay to engage in the very sorts of risks Dodd-Frank was designed to ameliorate, but they do so with a pittance of the oversight. While in a pinch these looming financial behemoths aren’t supposed to be able to count on government to provide the same level of protection, they’re securing for themselves a different (but very familiar) point of leverage: Some have become too big to (let) fail.

Eventually, the Federal Reserve will get inflation under control, hopefully via a “soft landing”—that is, without sparking a broad-based recession. But as rising interest rates begin to impact ordinary people with variable rate mortgages, car loans, credit card debt, and more, borrowers will inevitably begin struggling to pay. Banks, of course, must be ready for that moment—they’re required to maintain large reserve funds, to comply with strong risk management protocols and, in some cases, to endure regulators literally watching over their shoulders as they work. Moreover, they are all subject to frequent “stress tests” required by Dodd-Frank. But nonbanks are not subject to the same scrutiny. And if, during any future recession, some begin to teeter on the brink of bankruptcy, Washington will find itself faced with a familiar dilemma: Bail them out, or let the effects of their imprudence and/or bad luck spread across the rest of the economy.

There may yet be sufficient time to thwart that next Armageddon—Washington could embrace a new approach premised on the simple rule “same size, same activity, same regulation.” But to understand the crux of the problem, we must first grapple with the intricacies of the broader financial landscape. As the Lehman Brothers example made clear in 2008, the collateral damage of not providing a bailout to a behemoth financial institution can be profound. But that misses a deeper truth. By the time a big firm is calling for a bailout, the regulatory framework has already failed. The key is to nip imprudence in the bud and make sure all financial services companies have sufficient capital cushions. And that’s what we’re failing to do today.

Two Systems, One Country

It would perhaps be one thing if banks and nonbanks were in entirely different businesses—perhaps then policymakers could offer some reasonable explanation for why they’re regulated so differently. But the reality is that, since the Great Recession, the two categories of financial firms have become even more alike. Many from both camps offer home mortgages, for example, and provide credit card loans. A consumer trying to get a loan for appliances while fixing up his or her kitchen could go to a bank, for example and obtain a home equity line of credit or use his or bank credit card, alternatively this same person could go to a non-bank on the internet or otherwise and receive similar loans at similar APRs. But the former would be subject to capital requirements, supervisory scrutiny and serious safety and soundness rules while the second would be subject to almost no regulatory requirements let alone on site scrutiny . So much as they compete for the same customers, they’re subject to vastly disparate levels of scrutiny and financial cushions for rainy days.

In 2020, the banking sector’s primary federal regulators, namely the Office of the Comptroller of the Currency (OCC) (my former role) and the Federal Deposit Insurance Corporation (FDIC), boasted more than 5,500 employees in examination-related roles keeping tabs on 6,200 banks. (Of note, the Federal Reserve, which performs these functions for other banks, does not release comparable figures, though they have thousands supervisory employees.) But the Consumer Financial Protection Bureau (CFPB), created as part of Dodd-Frank, has only 625 examiners to cover 21,175 entities, some of which are banks, but most of which are not. This leaves those responsible for overseeing these newfangled financial houses almost entirely outgunned.

It’s not difficult to understand why that’s a problem. As of today, no one really knows exactly what’s happening in the nonbank financial universe—whether the big nonbanks would survive the sorts of stress tests banks must endure, or even whether they’re serving minority communities as banks are required to do. To that end, we don’t know what sorts of risks they’re imposing on the economy as a whole. But if reality is anything akin to what precipitated the Great Recession, the economy may be at much greater risk than we realize.

The divide that exists today between banks and nonbanks is an echo of the divergence that separated commercial and most investment banks during the previous “Glass-Steagall Era,” a period during which banking and securities activities were separate and separately regulated. Today, however, the nonbanks arguably enjoy even wider-ranging impunity than yesterday’s investment houses.

The core of the difference centers on the balance of each category’s rights and obligations: In exchange for the federal government’s implicit and explicit promises to extend “the federal safety net” to banks and their customers, chartered banks agree to endure a certain standard of federal monitoring and regulation. But hedge funds and private equity firms, among other nonbanks, sidestep that same scrutiny because they aren’t supposed to enjoy the privilege of a promised federal bailout.

Much as we may theorize that the government won’t come to the aid of nonbank financial firms, history has frequently demonstrated that, in many cases, Washington will end up swooping in as a savior of last resort. That’s what happened back in the 1990s when the federal government came to the aid of the wayward hedge fund Long-Term Capital Management, a firm whose failure threated to drag down the whole economy. That’s what happened again when regulators worked with the banking community to aid both Bear Stearns and Countrywide in 2008.

Nothing “legally” obligates taxpayers to bail out a huge nonbank like Blackrock or Vanguard if either began to teeter in the event of a major recession. But most everyone on Wall Street presumes that the government would step in were a nonbank that’s “too big to fail” to fall on hard times. That’s why, for all intents and purposes, Dodd-Frank’s ban on bailouts is a dead-letter. For the nation’s economic wellbeing, Washington could not reasonably afford to let them go bankrupt. And that then begs the question: If these companies are operating with so much of the upside of the federal safety net, why aren’t they subject to the same regulations and oversight as well?

The Mouse is Winning

In the wake of the housing market’s collapse more than a decade ago, nonbanks were originating a mere 9 percent of mortgages. But by 2021, they were supplying more than 64 percent of the nation’s home loans. And it’s in that context that the big nonbanks have figured out how to play the market. If they fail—or, should we say, when they fail—federal officials will have little choice but to bail them out. Impossible, some will say: Dodd-Frank outlawed bailouts. But, in the event of an emergency, Washington will find a way. In fact, the Fed has already shown its hand.

While not technically a “bailout,” the central bank’s decision in the early months of the pandemic to guarantee the value of junk bonds, namely the debt issued by companies at the greatest risk for being unable to make good, demonstrated the degree to which government can still come to the aid of troubled companies. The move guaranteed that companies which might otherwise have failed to stay afloat would be able to borrow, and that lenders would be made whole if the companies proved unable to service the debt. The same could be done for nonbanks. There’s no reason to believe they wouldn’t do the same thing in the future for any company whose default would have catastrophic effects on the economy.

But if Dodd-Frank has failed to disabuse nonbank financiers of the presumption that they could take imprudent risks knowing that the public will bail them out, the bill did at least establish a Financial Stability Oversight Council (FSOC), which was tasked with watching over “systemically important” (read: “too big to fail”) financial institutions. FSOC was designed to be a sort of star chamber, keeping watch on the big financial houses that were otherwise escaping strict scrutiny. And to that end, the Obama Administration made good, at least in part, by subjecting four big nonbanks—GE Capital, Prudential, MetLife, and AIG—to an extra layer of oversight.

But things changed again—as might have been expected. Regulation, after all, is little more than an endless game of cat-and-mouse. Savvy financiers are forever looking for ways to slip in bigger risks by exploiting cracks in any regulatory framework. To keep up, regulators must adjust in anticipation and, if not, in real time. But with FSOC, the mice have essentially won.

All four of the FSOC’s original wards are no longer under its thumb, and the Committee has yet to designate any new entity as a “systemic risk.” But some of the nonbanks now on the scene dwarf the market power wielded by the bad actors who have threatened the nation in the past. Which begs the question: Can we really afford to take for granted that they are safe and secure?

A Backdoor to Discrimination

There’s one final wrinkle to this story—one that centers on another crucial impetus for federal regulation. Today’s chartered banks are required by federal statute to serve low- and moderate-income Americans, particularly communities of color, to help ameliorate the racial wealth gap that remains so potent in contemporary American life. Discriminatory practices such as redlining prevented Black families from access to the American Dream during most of the 20^th century. To that end, since 1977, the Community Reinvestment Act (CRA) has forced banks to ensure that their lending practices, in particular, work to stamp out the legacy of American bigotry.

Unfortunately, the nonbank financial institutions now encroaching on the banking industry’s bread-and-butter have no CRA obligations whatsoever. Does that mean we know they’re imposing new redlining regimes? Many on Wall Street will scoff at the suggestion, arguing that some of these new firms market themselves explicitly as catering to middle- and low-income America.

Yet nonbanks frequently keep their costs down by replacing the sorts of labor-intensive underwriting procedures banks are required to perform, instead making loan determinations strictly on the basis of algorithms designed purportedly to weigh the risk of various loan portfolios. And that has the potential to be, well, problematic

Because wealthier white applicants often elicit higher scores than Black applicants, algorithms may well steer nonbank resources to white applicants. They may overcharge the poorer borrowers by assigning them higher interest rates. And they may not be as scientifically precise as some would have us believe. This then points to a principle that should bear on any regulatory regime: Efforts to impose restrictions on an institution’s behavior can only be as good as a regulator’s willingness to enforce the law in a full, fair, and an even-handed way.

Here, again, nonbanks operate at a distinct advantage over their chartered peers. In 2020, the FDIC and OCC filed approximately 300 enforcement actions against the nation’s banks. By contrast, the CFBP, the only federal agency with any real oversight for consumer protection over the wide-ranging universe of nonbank lenders, filed fewer than 50. That’s a yawning gap, and one that calls into question the impact the current regulatory regime is having on the legacy of American racism.

A Path Forward

The answer isn’t to ban nonbanks, or to put onerous restrictions on them such that they’re driven out of business. Competition is good for consumers, assuming it’s fair. Rather, we need to reform the nation’s regulatory regime so that institutions competing directly against one another are subject to the same standards and enforcement.

As Fed Chairman Jerome Powell has argued, often to deaf ears in Congress, the correct approach to regulation for all financial players is “same activity, same regulation.” Ongoing efforts to reform CRA regulations—what would mark the first real overhaul since the 1990s—may offer an opportunity to make some headway on this front. To the extent that completing the task might require legislation, CRA reform would at a minimum offer bank regulators the opportunity to advocate explicitly for a level playing field.

Second, we should make sure that the expansion of oversight does not cost taxpayers a dime—the burden should be borne by the lenders that are profiting from the implicit guarantee that, should they become systemic risks to the economy, the government will come to their aid. Already, regulated national banks are assessed fees to cover the costs born from the Comptroller’s office. By the same token, state-chartered banks pay for at least a portion of state-level bank supervision and regulation. The same model should apply to nonbanks.

Third, we should find ways to ensure that growth within the nonbank sector redounds to the benefit of those legacy lenders that have long done the work of serving marginalized communities. Today, many communities that would effectively be underbanked are served by a rare breed of mission-oriented institutions known as a Community Development Financial Institutions (CDFIs) and Minority Depository Institutions (MDIs), each of which specialize in extending credit and taking deposits from more modestly situated individuals, businesses, and families.

But CDFIs and MDIs are particularly vulnerable during economic downturns because their borrowers are often the first to lose their jobs and the last to get them back. Nonbanks could be required to help fund an emergency reserve for CDFIs and MDIs such that when they get into trouble, pooled resources exist to help them survive. The nonbanks which contributed to the reserve fund could get credits toward their new bank-like obligations under the CRA.

The worry today is not just that financial institutions outside the realm of America’s banking sector operate at an unfair advantage. It’s that the disparity reveals a lack of oversight in a growing portion of the Main Street economy. Absent a level playing field, the American economy faces the downside risk of having to account for an opaque set of lenders that nevertheless presume that the government will help them out of future jams.

Unless Washington wakes up soon, the economic threat potentially building in the nonbank sector could prove to be even more powerful than the peril that accrued quietly ahead of the Great Recession. We can’t know the future, and we should hope that efforts to stem inflation do not precipitate a wider recession. But a failure to nip these risks in the bud could overcome the guardrails we erected little more than a decade ago to prevent us from falling off the same “too big to fail” cliff, again.