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.