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The Case Against Restoring Glass-Steagall

WASHINGTON — Former Citigroup chairman Sandy Weill's call to reinstate Glass-Stegall has sparked a growing countermovement among those that argue restoring the Depression-era law would not make the system safer.

The naysayers are hoping to outmaneuver policy heavyweights like Tom Hoenig, a director at the Federal Deposit Insurance Corp. and former president of the Federal Reserve Bank of Kansas City, who say separating commercial from investment banking is the only way to prevent another financial crisis.

The list of skeptics includes former bank executives and regulators from both political parties, including Richard Kovacevich, the former chairman and chief executive of Wells Fargo, Steven Rattner, former counselor to Treasury Secretary Timothy Geithner, and Rob Nichols, a former Treasury official in the Bush administration and now president of the Financial Services Forum.

"Glass-Steagall never solved any real problems," said Wayne Abernathy, the head of financial institutions policy and regulatory affairs at the American Bankers Association. "I haven't found anyone at all that has been coherent in outlining [the argument]. It's all been mystical. It will make the world better. It will make things less risky. They've never really hooked up cause and effect. The riskiest thing that a bank does … is loan money to somebody."

The allure of Glass-Stegall, the 1933 law that banned commercial banks from owning investment banks, has become so prominent that a recent episode of HBO's The Newsroom said its repeal was the cause of the 2008 financial crisis.

But many current and former industry and regulatory officials take issue with that idea, saying the crisis and the 400-plus bank failures that resulted had nothing to do with the mix of commercial and investment banking.

They point to Bear Stearns, Lehman Brothers and Merrill Lynch as proof, as all three investment firms were at the center of the crisis, but were not owned by commercial banks at the time (Bear was eventually bought by JPMorgan Chase, while Merrill was purchased by Bank of America). Had Glass-Stegall been in effect in 2008, they argue, Bear, Lehman and Merrill would still have collapsed. Nor would the law have prevented the fall of insurance giant AIG or real estate investment trust New Century Financial.

The primary cause of the crisis, they say, is the proliferation of exotic mortgage products that were securitized and sold off across the market. Nothing in Glass-Steagall would have prevented such loans from being originated, sold and securitized.

"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," William M Isaac, a former chairman of the Federal Deposit Insurance Corp., and Kovacevich wrote in an editorial in the American Banker.

To be sure, Steven Pearlstein, a columnist for The Washington Post, notes that investment bank activities in the U.S. created a shadow banking system outside of regulators' jurisdiction, which helped encourage sloppy lending practices.

Still, Pearlstein is unconvinced Glass-Steagall would have stopped the crisis.

"Repeal of Glass Steagall has become for the Democratic left what Fannie Mae and Freddie Mac are for the Republican right — a simple and facially plausible conspiracy theory about the crisis that reinforces what they already believed about financial markets and economic policy," he wrote in a recent column.

Rattner, a former Obama administration official, said the crisis is regulators' fault, not the repeal of Glass-Steagall in 1999 in the Gramm-Leach-Bliley Act. He blames "old-fashioned poor management that expanded the banks' portfolios and activities too aggressively without sufficiently robust risk controls, enabled by lax (or nonexistent) oversight by regulators."

"Many of those excesses were concentrated in the housing sector, where a now a legendary bubble formed without regulators or industry leaders recognizing it," Rattner wrote in an op-ed in The New York Times.

Both Isaac and Kovacevich agree.

"Unfortunately, regulators failed to see or act on the problems until they escalated into a full-scale crisis," write Isaac and Kovacevich. "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."

A return to Glass-Steagall would be disastrous, many argue. They predict further consolidation, a reduction in lending and a smaller banking industry share of the economy.

"If you want a smaller, dwindling banking industry, which has been the most heavily regulated part of the financial services industry, then Glass-Steagall will give you that," said Abernathy. "But I think it's arguable whether that's good for the industry or for the industry's customers."

Others, like Tony Fratto, a former Treasury and White House official in the Bush administration, said that breaking up the banks will wind up raising the costs of U.S. businesses and reduce banks' competiveness globally.

In a recent blog post, he warned that the banking system must be able to grow larger to deal with an ever increasing global economy.


(6) Comments



Comments (6)
Glass-Steagall and much of Regulation Q was initiated during the Great Depression to uphold unit banking and the real bills doctrine. Calomiris provides a convincing argument and goes in-depth in his 2010 paper The Political Lessons of Depression-Era Banking Reform - http://www.aei.org/article/the-political-lessons-of-depression-era-banking-reform/

Unfortunately, the root cause of the crisis has not been addressed - the mispricing of mortgage risk which eventually led to the failure and conservatorship of Fannie and Freddie. Edward Pinto, ex-Fannie credit officer, calculated that the GSEs held nearly half of the world's subprime and Alt-A at the time of their failure. Now, how does owning nearly half of a market, not "make a market"? Yes, mortgages were pooled and securitized by universal banks and investment banks, but that will always be the case when a buyer exists. See literature from hearings with Oversight and Govt. Reform - http://democrats.oversight.house.gov/index.php?option=com_content&task=view&id=4712&Itemid=2

If we reduce the size and role of U.S. banks, big banks will not disappear, they will just be from other countries. That's why GS reform took place - it was anti-competitive. Instead, banks need to create more diversified revenue streams and increase capital levels. This is already being done via the market's natural incentives and regulatory standards.
Posted by @Patrick_J_Sims | Wednesday, August 08 2012 at 12:14PM ET
Glass steagle was eliminated because greedy bankers and gangsters wanted it removed. In this case it was removed becasue a man's vision of a financial supermarket was imposed because money was used to buy influence in 98 under President Clinton and encouraged by Alan Greenspan. Removal of Glass Steagle was a major policy blunder by the Federal Reserve and it enabled Banks to originate loans, then act as servicers and take into inventory financial products created by wall street investment banks. The removal of Glass Steagle allowed banks to be tempted by higher yields of MBS and they thought they could insulate themselvews from risk by designing CDS. In the end, the market players faded regulatory processes and eventually the whole thing blew up leaving the bad guys getting rewarded! The common sense reality is that banks and investment banks are opposites! You cannot insure deposits and then allow banks to invest in high risk products designed by wall street! We have known this since the thirties!
Posted by lauberge | Wednesday, August 08 2012 at 10:38AM ET
Loans are NOT the riskiest thing a Large Bank does. Total return swaps, and other highly structured products, hidden off balance sheet for years, and away from Board oversight are by far the riskiest thing a large bank can do. A loan means a business or a person is engaged in tangible economic activity. A trading book swap is a net zero sum game. Lets bank in the real world again.
Posted by Old School Banker | Wednesday, August 08 2012 at 10:07AM ET
I would agree that Glass Steagall wouldn't have prevented the recent recession, caused by excessive risk taking, astronomical leverage, skirting common sense mortgage lending and regulators who showed up after the barn doors were wide open. I don't think the desire to revive Glass Steagall is to correct the wrongs that led to the recession, but to prevent the inevitable and inherent problem of investment banks marrying commercial banks. JP Morgan Chase & Bear Sterns and BofA Merill Lynch. If you think these bright minds will not figure out a way to co-mingle bank deposits and investment dollars you might want to look more closely at what caused the great depression. Glass Steagall; not a palliative for the past, but a safe and sound preventative for the future. Let the investment banks do what they do best, regulate their activities much as commercial banks are regulated and the result will be stronger and safer financial markets.
Posted by Tmcgraw | Wednesday, August 08 2012 at 9:32AM ET
"They've never really hooked up cause and effect. The riskiest thing that a bank does ... is loan money to somebody." If that were true, the secondary market would not have collapsed! The riskiest thing banks do is trying to find ever more investment vehicles and getting away from the core business of banking and that is what Glass-Steagall seeks to accomplish.

When I was a statistician for American Banker in the 80s, banks found themselves competing with investment banks for the then much coveted MBA graduate. They thought themselves at a disadvantage because banking back then was staid and boring. Core earnings didn't explode, Money Center banks had to be content with ROA of 9% and ROE of 11.

Then Asset-Backed Securities began to take off and banks went into the market enthusiastically, with mortgage- and credit-card-backed debt. It didn't take long for the market to collapse with a flood of garbage MBS from First Boston. The market was a lot smaller then, but the industry hasn't learned very much.

Back then, issuers took back the securities and properly repackaged them. The top mortgages were of course gobbled up, but the industry discovered something else. Even the high risk securities went quickly. In some cases, even faster than the top rated MBS. As long as investors knew what they were getting, they were willing to take the risk.

There were other wild and un-wise antics during those days just before the end of Glass Steagall. The hostile takeover craze, brokered deposits, etc. All of it only emphasized the difference between commercial and consumer banking and investment banking. This only happened 30 years ago, yet all of it has already been forgotten.
Posted by RSE Journal | Wednesday, August 08 2012 at 9:27AM ET
I agree with your argument, but not your conclusion. You are right... Glass-Steagall would not have prevented the 2008 credit crisis. Banks had been working around the edges of the 75 year old Act for some time. By securitizing their pools of subprime mortgages banks let Bear Stearns and Merrill do their underwriting for them. By taking huge bets in proprietary trading in currencies and derivatives they were able to avoid the constraints of their regulators. The point is that federally-insured entities should lend money conservatively - pure and simple. Anyone else can gamble any way they want as long as they do not put the economy at risk. This means that we are ready and willing to let them fail. Should we bring back Glass-Steagall? Yes - but make it Glass-Steagall 2.0.
Posted by @banklawguy | Wednesday, August 08 2012 at 9:25AM ET
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