The contours of the 21st-century Glass-Steagall Act that both the Trump administration and many in Congress are talking about are not at all clear, but it is important for everyone to understand what dangers lurk in reducing the ability of banking organizations to compete in a constantly evolving financial system.
The Gramm-Leach-Bliley Act of 1999 formally overturned the Glass-Stegall provisions that prohibited affiliations between banks and firms that underwrite or deal in securities. Reinstating this prohibition seems to be the major goal of those who support a Glass-Steagall reboot. But there are important reasons for banks, through their holding companies, to be affiliated with securities firms.
Since the mid-1980s, companies have increasingly chosen to finance their operations by issuing debt securities rather than borrowing from banks, and that gap is rapidly widening. According to Federal Reserve data, corporate debt securities totaled nearly $6 trillion last year, compared with nearly $2 trillion in C&I loans, a difference of 200%. In 1985, that difference was just over 34%.
This trend is based on fundamental changes in the financial economy and appears to be irreversible. First, banks are heavily regulated principal intermediaries; they have to pay high regulatory costs as well as the costs of the deposits they lend to corporate borrowers. Securities firms, however, are agency intermediaries, have lower regulatory costs and do not have significant costs of funds. They can underwrite or place corporate debt securities for a modest fee, and the issuers, on net, can normally obtain lower rates from investors than from bank subsidiaries.
In addition, although longer-term debt securities are generally issued under trust indentures, the cost of complying with the terms of these formulaic contracts are much lower than negotiating a loan agreement with a bank lender and responding to the regular and highly specific information requirements that loan agreements frequently entail.
Finally, since the mid-1980s, technologically driven changes in communications have made corporate financial information more easily available to investment advisers and investors themselves. Xerox copying and fax machines permitted wide dissemination of the financial data that companies filed with the Securities and Exchange Commission, reducing or eliminating the information advantage that was once a unique property of banks.
Today, banks are still the high-cost providers of loans to firms that are large enough to register debt securities with the SEC.
Although the registration of securities has become more expensive, it is still less costly for large firms to finance their growth with debt securities than through bank borrowings. Small firms that do not want — or cannot afford — to register with the SEC must still borrow from banks, and have paid the steep price of the additional regulations imposed on banks by the Dodd-Frank Act.
Given these facts, it is hard to understand the thinking of those who would restore the Glass-Steagall prohibition on affiliations between banks and securities firms.
Underwriting and dealing in securities are not as risky as making loans. When a bank makes a loan, it puts the cash amount of the loan outside its control. The borrower has the funds, and can often take risks with these funds that the bank cannot restrict. On the other hand, a firm that deals in securities always has control over its assets and can easily reduce its risks on this inventory by selling or hedging. Underwriting is even less risky, since the securities underwriter does not actually purchase securities from the issuer until buyers have committed to take virtually all of them. In other words, preventing bank holding companies from engaging in these activities would increase risks rather than reduce them.
But there is a broader point, as shown by the disparity between C&I loans and debt securities. If the 21st-century Glass-Steagall Act is intended to prevent bank holding companies from controlling any businesses other than banks, how are they supposed to be sources of strength for their bank subsidiaries, and how are the banks themselves going to survive when the financial markets are decisively moving away from the costly principal intermediation that is the hallmark of a bank?
The answer is to maintain banks where most are today, within a diversified holding company that can enter any financial business, including underwriting and dealing in securities. Then, if banks have to downsize over time — as current trends suggest — this can gradually be managed by the holding company, without costly and unnecessary bank failures.
No one can predict the future, but what we know is that diversification is the surest way to avoid financial risk. Banking organizations, like other businesses, must be able to respond to the constant changes in our economy. If a 21st-century Glass-Steagall — whatever that is — will restrict banks to one line of business, or fence them out of growing sectors of the financial economy, it is more than shortsighted; it is a prescription for eventual and costly failures.