The whole fight of the great bankers is to drive us from our firm resolve to break down the artificial connection between the banking business of this country and the … speculative operations at the money centers. … Under existing law we have permitted banks to pyramid credit upon credit ….
While this sounds like a contemporary call to action, it actually was part of an impassioned speech by then-Representative Carter Glass before the House of Representatives in September 1913. Representative Glass was one of the architects of the Federal Reserve Act, which established the federal reserve system. Later, in response to the Panic of 1929, as Senator Glass, he fashioned the Banking Act of 1933, which popularly was called the Glass-Steagall Act. The Glass-Steagall Act was part of the comprehensive legislative response to economic and banking conditions similar to those that led to our financial crisis today. .
The Glass-Steagall Act essentially defined the proper roles and assumable risks of commercial banks. In short, it separated the business of commercial banking from the business (and corresponding speculative risks) of investment banking. When banks serve as both lenders for and investors in securities (including their derivatives) — and "pyramid credit upon credit" — they are perceived as serving conflicting interests, benefiting only insiders and weakening protection for depositors and the general consuming public. By limiting the types of risk that commercial banks may properly assume in conducting their business, the Glass-Steagall Act effectively restored the country's banking system to sound, sustainable financial health.
The dismantling of "the Glass-Steagall wall" through the 1990s structurally allowed risks in the banking and investment spaces to be mixed — leading to a toxic, and increasingly opaque, combination, which created an environment ripe for financial failure and crisis. This environment of speculative, risk-pervasive, opaque banking and securities (including derivatives) practices is akin to the tragic environment that the Glass-Steagall Act and its sister federal securities acts were designed to address nearly eight decades ago. Today, we need to resurrect, and adapt to modern conditions, some form of the Glass-Steagall Act.
Our successful Glass-Steagall heritage, while it was in full force, suggests an approach to financial reform that is relevant today. Current reform strategically should consider at least the following features.
Structural and preemptive financial reform. The new reform should define the scope of permissible enterprise risk that banks may undertake in the conduct of their business, much like Glass-Steagall did. Erecting a "wall" to avoid the toxic mixture of speculative and productive risks is again needed. Whatever shape current reform ultimately takes, it should not allow financial institutions that are stewards of depositor and commercial capital to expose that clientele (the public) to the disparate, speculative risks of investment banking. In this respect, it should be preemptive: it should be designed to prevent financial disaster, not simply to mitigate its aftermath. That was the simple design of the Glass-Steagall Act.
Market-sensitive regulation. The reform should support, but not stifle, competition in the marketplace. Financial innovation should continue to be encouraged, particularly with respect to the development of better risk management tools. However, this reform will need to strike a prudent balance: it must structurally compartmentalize risk and effectively preempt toxic mixtures, while avoiding both disabling financial institutions from being competitive and enabling them to squelch their competitors and adversely impact our economy.
Market-smart regulatory framework. Reform and the regulators assigned to oversee it should be market-smart. However the regulatory framework eventually shapes up, it must be able to identify commercial and financial practices that, if left unfettered, could lead to another toxic combination of risks, ultimately damaging our financial system, our economy and American lives. The new framework should be designed and supported with adequate resources in order to minimize the risk of market participants "outsmarting" the structural limits of permissible, transparent, conflict-free risk-taking. Reform should intelligently perform these risk-regarding tasks.
Systemic stability. New regulation of the financial system should help to ensure systemic equilibrium and to avoid systemic failure. Going forward, this should be accomplished without resort to government-funded bailouts. New regulation should encourage deleveraging the balance sheets of overly extended financial institutions via the marketplace, not Uncle Sam. In other words, financial reform should facilitate enforcement of the newly "walled" boundaries of enterprise risk, thereby promoting sound systemic conditions.
Derivatives risk management. Reform should recognize that there is a proper role for the use of derivatives by private business: risk management. For example, an integrated energy company may utilize derivatives (in a costless collar arrangement, for example) to prudently limit its downside commodity price risk. It is when derivatives are used for speculative profit (think Enron, for example), rather than for prudent risk management purposes, that financial problems typically arise. Reform carefully should be developed to permit the use of derivatives for risk management purposes but to guard against a firm's scaling the wall and entering the predetermined forbidden space of high-risk speculation.
Stress testing. New market-smart regulation should include improved stress testing. Regulatory assessments of an institution's and the financial system's current and projected financial conditions should be empirically based. They should employ best analytical practices, business intelligence and market information. Those determinations should be as objective as possible and should not be based on conflicted, self-regarding modeling.
All of us will be served well if the discourse in Washington is well informed. The foregoing considerations are not intended to be comprehensive but are merely suggested as guiding principles — inspired by what we hopefully have learned from the (recurring) past.