What does a 21st-century Glass-Steagall look like?
WASHINGTON — Despite a general lack of specificity about what exactly it would entail — or maybe because of it — the idea of a so-called 21st-century Glass-Steagall Act remains surprisingly durable.
Both Treasury Secretary Steven Mnuchin and Sean Spicer, the White House's chief spokesman, have said it remains on President Trump's agenda, while Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig recently outlined an idea that might qualify as a modern version of the 1930s-era law.
Yet there is no widespread agreement about the specifics of a modernized version of the separation of investment and commercial banking.
“I don’t really know what a 21st-century Glass-Steagall would look like," Federal Reserve Board Chair Janet Yellen said in a passing comment at her last press conference.
For right now, Hoenig's proposal may be the best clue, in part because there are no other real contenders. Hoenig, who reportedly is one of several being considered as vice chairman of supervision at the Federal Reserve, two weeks ago outlined a plan to effectively ring-fence the depository and lending portions of a bank from other more exotic banking activities like securitization and market making. Each operation would have its own board of directors, stock and capital requirements.
Karen Shaw Petrou, managing partner at Federal Financial Analytics, said the concept of ring-fencing commercial and investment banking activities may seem at odds with the administration’s overarching deregulatory push, but Hoenig's plan sounds in line with what the administration is seeking.
“One of the reasons I think it has legs is that it has a very constructive potential solutions to it, in terms of trying to resolve the unfinished Dodd-Frank business,” Petrou said. “They have to come up with a plan, and this one could be it.”
Dennis Kelleher, president of the public advocacy group Better Markets, said the fact that Hoenig is putting some thought into a modernized Glass-Steagall means that he sees a practical way forward in reducing or eliminating the moral hazard of bank bailouts while protecting the financial system. The administration may not opt for some iteration of Glass-Steagall because it is politically expedient, he said, but because it may just work.
“Hoenig is a very serious, almost … he’s like the un-politician,” Kelleher said. “He’s not doing a political calculation. He’s trying to figure out what would really work to make sure the safety net is not extended to anything that does not have a clear social purpose — lending, commercial banking in the historic sense, however you want to characterize it.”
There have been misgivings about the erosion of the barriers between commercial and investment banking almost since the passage of the Gramm-Leach-Bliley Act in 1999.
That law allowed some commercial and investment activities to be housed under the same bank holding company in a way that had been prohibited for decades, though it did not eliminate all restrictions — Section 23a of the Federal Reserve Act, for example, limits the kinds of transactions a bank can undertake with its affiliates.
Nonetheless, in the decade after Gramm-Leach-Bliley passed, banks got bigger and commingling of commercial and more exotic functions expanded, leading many Wall Street critics — including Sen. Elizabeth Warren, D-Mass. — to call for a reinstatement of a harder barrier between the activities after the 2008 financial crisis.
A straight-up return of Glass-Steagall is unlikely because it would be exceedingly disruptive. More likely would be something akin to Hoenig’s plan, setting tailored capital levels for different activities commensurate with risk. But the specifics of where those capital levels ought to be, Petrou said, vary significantly and have significant impacts on the industry.
“Once you go beyond the very broad strokes, the details really matter … not only in the pragmatic winners and losers, but in the policy consequence,” Petrou said.
Federal Financial Analytics recently outlined some of those broad strokes in a policy memo, which includes some conclusions. One of them is that community banks largely benefit from a reduced big bank market share, and midsize regional banks will win or lose depending on how extensive their nontraditional activity footprint is.
For the largest banks, the effect depends largely on the individual bank's structure. If the proposal, like Hoenig’s, sets a 10% equity capital ratio on commercial banking activities and a somewhat more flexible capital regime on investment activities, then some banks would be able to meet that ratio and others would not, the paper says.
Christopher Whalen, chairman of Whalen Global Advisors, said that any new iteration of Glass-Steagall should emphasize protecting the depository institution — and in turn protecting the taxpayer through deposit insurance — rather than preventing bank-affiliated broker-dealers from taking on excess risk.
Risk-taking is going to happen in broker-dealers anyway, Whalen said, and if appropriate protections are in place the failure of one or several institutions might be done in a relatively orderly way. And if commercial activities are truly segregated from that risk-taking, banks might finally be able to compete with independent brokers, he said.
“If we go down this road, the independent broker-dealers will grow, and they’re going to get bigger, and people are going to want to put capital into them because returns are going to be higher,” Whalen said. “The risk will be higher, but I think they can manage that. To me, I want that risk in the private sector. I don’t want it inside of banks.”
Whalen added that the administration should consider changing the Volcker Rule to allow those segregated broker dealers to trade on their own account, since they would be segregated from their depository affiliates and therefore could not use depositors’ funds to advance their own interests.
“The key tweak is, the dealers, the fund affiliates of a bank holding company can trade for their own account, but they cannot interact with the bank and the conflict rules regarding lending remain in place — such that the lending function and the securities function have to be completely separate,” Whalen said. “You do that, and I think you’ve got a winner.”
But if the regulatory burden is too deeply felt by the deposit-taking side of the bank than the investment portion of the firm, it could encourage those institutions to attempt not to be bank holding companies at all. For banks that only became holding companies under duress during the throes of the crisis — Morgan Stanley and Goldman Sachs — this might be especially tempting.
But those banks would run up against section 117 of Dodd-Frank, the so-called Hotel California provision in the law that effectively stipulates that once a bank holding company, always a bank holding company. That provision could be repealed, and Petrou said that change alone could make a new Glass-Steagall — not to mention the rest of regulatory reform — effectively moot for some banks.
“It’s in play,” Petrou said. “If you repeal Hotel California, some companies aren’t going to give a hoot what the holding company capital requirement is, and they might not even care what goes where, because they’re out of there.”
Ron Meyer, a senior business adviser at the data services firm Linedata and former commercial banker, said that whatever the administration chooses to do, the chances are that the commercial and investment banking business lines will continue to evolve independently.
“No matter what happens, in the end whatever investment banking is doing, investment banking will continue to do … and whatever the commercial bank does, it will continue to go its own way as well,” Meyer said. “In my opinion, if you ring-fence these two operations, I think [they] act in the same capacity that they act today.”
Greg Lyons, partner with Debevoise & Plimpton, said that public perceptions notwithstanding, bank regulations have already achieved much of what any 21st-century Glass-Steagall would mean.
Gramm-Leach-Bliley left significant barriers in place between banks and their broker-dealers, and Dodd-Frank boosted bank capital and limited the more pernicious aspects of self-interested dealing via the Volcker rule, he said. And when it comes to the interconnectedness that made an institutional failure like Lehman Brothers so systemically toxic, he said, Dodd-Frank’s living wills process has already pulled apart most banks’ business lines so that sense could be made of them in the event of a crisis.
“Many of the resolution planning [advances] should help to deal with that,” Lyons said. “As far as the inherent riskiness of the bank being affiliated with a broker … Section 23a [of the Bank Holding Company Act] and the Volcker rule put real limits on what the relationship between the bank and the broker can be.”
Lyons said that an elaborate Glass-Steagall proposal is probably not going to happen, if for no other reason than because it has the potential to make U.S. banks even nominally less competitive with banks in Europe and Asia.
“I have not heard anyone say, ‘We are planning to get rid of our broker-dealer,' ” Lyons said. “I personally think it’s a very slim chance. This administration is very focused on American enterprises’ ability to compete with foreign enterprises. There’s no doubt that if you have to cleave off your broker, it will make it more difficult.”
But Kelleher said the administration and Congress should resist the temptation to deregulate the banking sector in the name of competition from shadow or foreign banks. Risk should remain where regulators can see it, he said, and the administration should avoid racing to the bottom of supervisory expectations.
“If the only financial institutions that are properly regulated are bank holding companies, then you have lit the fuse that will lead to the dynamite that will blow up the financial system in a few years,” Kelleher said. “And it will be the shadow banking system. Again.”