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Restoring Glass-Steagall Would Bring Back Bad Apples

Sandy Weill, the former chairman and CEO of Citigroup, is the latest luminary to suggest that we restore the Glass-Steagall Act and, once again, separate investment banks from commercial banks.  What are they thinking?

Roughly 20 financial institutions were the major perpetrators of the recent financial crisis and the resulting great recession, primarily through the origination, securitization and distribution of exotic subprime mortgages with toxic features such as negative amortization and teaser rates, with stated incomes and reduced documentation.  The institutions included about six investment banks that securitized and distributed mortgages originated by thrifts and nonbank lenders such as Countrywide, Washington Mutual, Indy Mac, Option One, First Franklin, New Century, and First Financial and by state-chartered mortgage brokerages, many of which  committed outright fraud.  

It should be noted that these savings and loans were the remnants of an industry that cost taxpayers some $150 billion during the 1980s and early 1990s.  Burn me once, shame on thee.  Burn me twice, shame on me.

The majority of the borrowers with these high-risk mortgages lacked sufficient income to pay back their mortgages and a significant percentage failed to make even their first payment – a whopping 50% defaulted within a year. The scheme went undetected by many because rapidly increasing housing prices offset the cost of foreclosures.  

Unfortunately, regulators failed to see or act on the problems until they escalated into a full-scale financial crisis.  Rating agencies, unbelievably, rated significant tranches of these high-risk mortgage-backed securities AAA.  By mid-2008 Fannie Mae, Freddie Mac and other government agencies owned or insured over 70% of these risky mortgages, according to research by Ed Pinto at the American Enterprise Institute.  The SEC failed to monitor the 30-times-plus leverage of the investment banks and their inadequate liquidity with short-term (90 days or less) wholesale funding of trillion-dollar balance sheets.  

Notably absent from this array of culprits were commercial banks, with an exception or two.  Yet, commercial banks were demonized and vilified by politicians and protestors.  Congress imposed over 10,000 pages of new regulations on commercial banks, even though they did not create the crisis.  Why punish 7,000 commercial banks (and their customers) that did no wrong?  

As a consequence of the crisis, the offending investment banks and S&Ls were either sold, liquidated or converted to regulated banking companies.  The crisis is not even over and there are already calls to recreate the investment banks by restoring the Glass-Steagall Act to allow them to once again operate outside the regulated banking system.  

Some people mistakenly believe that investment banking is so risky that it should be separated from commercial banking.  In truth, traditional investment banking entails very little risk and certainly less risk than traditional commercial banking. 

Traditional investment banks engage primarily in underwriting debt and equity for corporations; providing advice on mergers, acquisitions and divestitures; buying  and selling securities for institutions; and helping clients hedge their interest rate, commodity, and foreign exchange risks.  In carrying out these activities, investment banks accept very little risk on their books. 

In contrast, commercial banks extend credit to individuals and businesses and retain a good deal of credit and interest rate risk on their books.  Why should we prohibit commercial banks from providing fee-based, relatively riskless traditional investment banking services to their clients and diversifying the banks' sources of revenue?      

Investment banks – and commercial banks, for that matter – become risky when there is a large proprietary trading, private-equity "hedge fund" inside the bank accounting for a significant percentage of the revenue.  This is the activity in which danger lurks, and it should be strictly limited and regulated.

We should not put our economy at risk again.  The last two major Wall Street houses standing are organized as bank holding companies, and that is positive for the safety and soundness of the financial system.  As a result, investment banking is now either part of the regulated commercial banking industry or is conducted in smaller boutique firms that are not highly leveraged.  A separate hedge fund industry exists for private investors interested in proprietary trading, private equity, exotic structured product securitizations, and other high-risk businesses.

Large, highly leveraged investment banks engaged in high-risk trading for their own accounts are finally gone.  Good riddance.

 Richard M. Kovacevich is the retired chairman and CEO of Wells Fargo & Co. William M. Isaac, former chairman of the Federal Deposit Insurance Corp., is senior managing director and global head of financial institutions at FTI Consulting, chairman of Fifth Third Bancorp and author of Senseless Panic: How Washington Failed America. The views expressed are their own.


(16) Comments



Comments (16)

This is the sort of self serving crap that provokes the lowest level of consumer confidence in the financial sector since the Depression.

I didn't think it possible for finacial services to be trusted less than BP & Congress. Guess not.

At least the credit unions will be busy on Monday.
Posted by JeffreyLAllenBroker@gma | Saturday, August 04 2012 at 7:21PM ET
These discussions would be much more rational if many of the fulminators understood what the word "bank" means. Gramm Leach Bliley, which repealed Glass Steagall, did not permit the kind of bank that holds deposits and is insured by the FDIC to engage in the kinds of securitization activities that caused the housing crisis. GLBA only allowed a holding company to own separate subsidiaries that engaged in various financial activities. Commercial banks operate separately from affiliates that underwrite securities and engage in proprietary trading. The SEC and the rating agencies are the bogymen here. The SEC supposedly had a more rigorous regulatory scheme for the five largest securities companies (aka investment banks) that looked at capital adequacy, risk controls, etc. That should have caught any securitization program pumping toxic loans out to investors. Similarly, the rating agencies should have seen the growing risks as underwriting standards for the assets supporting the CDOs and MBSs collapsed. Commercial depository banks did not cause this problem. Some of the securities companies that did cause the problem happened to own subsidiary commercial banks but that had no connection to the securitization programs. So reenacting Glass Steagall would be window dressing. According to studies by the FDIC in the 1980s, Glass Steagall was also window dressing when it was originally enacted.
Posted by gsutton | Friday, August 03 2012 at 6:42PM ET
The following comment is from William Isaac, one of the authors of the post above:
"It appears several readers believe the article by Dick and me is touting Wall Street and is anti-regulation. This is difficult to understand, as we state clearly that a major cause of the crisis was that the SEC failed to properly regulate the over-leveraged, ill-liquid major Wall Street firms, and we favor subjecting them to stronger, bank-type regulation. We have also argued in many forums that bank regulation itself is inadequate and needs to be made more efficient, less burdensome, and much more effective. We have also argued for greater marketplace discipline and an end to too-big-to-fail by imposing 'haircuts' on all large creditors of all failed institutions.
"The Dodd-Frank Act is not a proper response to the crisis. Those who would preserve or restore the status quo that led us into the last two banking crises are misguided. We can and must do much better."
Posted by Marc Hochstein, Editor in Chief, American Banker | Friday, August 03 2012 at 9:15AM ET
For the banker, growth provides many desirable if not essential benefits. When growth eclipses the banker's ability to manage it effectively, sudden collapse is often the first clue. Money market banks have long since exceeded a level of complexity susceptible to hands on control by a single individual. In reality, these behemoths are no longer captained by one but the many. Well designed and executed controls, good executive selection and effective reporting lines all help to manage these risks. Nevertheless, no set of management tools can equal the advantage of having one mind fully conversant with the business and all the risks it embodies.
Posted by Bigfoot | Friday, August 03 2012 at 7:42AM ET
I AGREE with most of the previous posts. The crisis was caused by utterly irresponsible LENDING and SECURITIES ISSUANCE. Banks benefit from issuance EXEMPTIONS which place them far from the reach of the SEC. Meanwhile, we have Goldman and Morgan Stanley chafing at the restrictions associated with the absurd status (accorded them by Geithner) of "bank holding companies."

So far, the CFPB, which can regulate mortgage originators, has been interested only in marketing tactics, not in product and underwriting absurdities. The SEC doesn't seem to care if bank-issued securities are mislabeled.

Securities fraud, a principal cause of the crisis, should be regulated by the SEC, without any bank exemption. Irresponsible mortgage lending should be repressed by the CFPB, since every borrower is a consumer.

To make this work, get banks OUT of the asset-backed securities business, and any securities business. JPMorgan Chase is an example of banks engaging in the securities business, under the incompetent banking regulation now available.
Posted by andrewkahr | Thursday, August 02 2012 at 6:35PM ET
Bill Isaac and Kovacevich are absolutely correct in their thinking, however, I doubt very much that all the powerful special interests will permit the type of restrictions that governed the past to prevail in this day and age. Some type of limitations are very necessary, supplemented by strong bank supervision and oversight;-the way it used to be when Regulators regulated!
Robert H. McCormick
Posted by Big Bob | Thursday, August 02 2012 at 5:51PM ET
Restoring the institutional separation and protection of Glass-Steagall doesn't mean that investment banks are going to be freed to participate in the risky and quasi-criminal behaviors that led to the meltdown. They should and likely would be regulated in a manner appropriate to their activities and risk, with special attention paid to proprietary trading, exotic swaps, etc. That is, if regulatory capture isn't fully restored after the next election.

Higgins23 hits it on the head: split them and regulate them accordingly.
Posted by j.doe | Thursday, August 02 2012 at 4:35PM ET
It is true that it wasn't sales and trading but proprietary trading that contributed to losses on private label securitization. But F&F total credit related losses are about 15 times that of the private mortgage insurance companies. How did they dodge the bullet? They were bypassed by purchase money seconds. Who funds seconds? Over 90% are funded by the banks (and other insured depositary institutions).
Posted by kvillani | Thursday, August 02 2012 at 4:12PM ET
I previously had some respect for Issac and quite a bit of respect for Kovacevich but their argument is laughable for all the reasons noted above. Commercial Banks will simply adopt the risky behaviors of the Investment Banks to lift earnings and their stock price. We all witnessed one of the the most conservative banks in the world (legacy Wachovia) succumb to stock valuation pressure in the late 90's thus stepping outside their traditional strong Credit culture in attempts to inflate earnings. Really poor logic Bill and Dick!
Posted by bo4107 | Thursday, August 02 2012 at 3:59PM ET
Simple. Split them and regulate them accordingly.
Posted by higgins23 | Thursday, August 02 2012 at 3:51PM ET
Simple. Split them and regulate them accordingly.
Posted by higgins23 | Thursday, August 02 2012 at 3:51PM ET
Let me see... Glass Steagall was in place in 1933 then repealed by Clinton in 1999 and in 2008 we experienced a huge banking disaster, the largest since 1929. It only took nine years to bring down the house. Don't you think it would be a good idea to bring Glass Steagall back? Of course the chance of that happening is almost none existent now that banking interests control our government.
Posted by Bill Ladewig | Thursday, August 02 2012 at 3:28PM ET
What on earth are these two distinguished gentlemen smoking? There are some arguments big banks can make in their defense, but this piece is quite possibly the most specious I have read.
Posted by Lawrence Baxter | Thursday, August 02 2012 at 2:42PM ET
The Foxes telling us they will protect the hen house
Posted by ToBig | Thursday, August 02 2012 at 2:01PM ET
The Foxes telling us they will protect the hen house
Posted by ToBig | Thursday, August 02 2012 at 2:01PM ET
I am shocked, shocked that Isaac and Kovacevich would write such an article- NOT! Wow! Wall Street is bringing out every Wall Street water carrier they have. I guess we will have to suffer through a steady tattoo of these kinds of opinion pieces until they beat Sandy Weill to death. I just wish these water carriers would present new and fresh arguements instead of dusting off the same old hackneyed arguements we always hear from these guys. It is so coordianted that you wonder if a memo went out from all the trade groups to which the SIFIs belong with orders to defend the Street at all costs.
Posted by commobanker | Thursday, August 02 2012 at 1:58PM ET
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