As Dodd-Frank has reached its fourth year, there are increased calls to prohibit bank holding companies from engaging in particular financial activities a holding company version of the "narrow banking" concept of the early 1990s.
The Federal Reserve has indicated that it is re-examining whether physical commodity activities are permissible under the Bank Holding Company Act and may impose increased capital charges on them, with Sen. Sherrod Brown, D-Ohio, scrutinizing such activities as well. Sens. Elizabeth Warren, D-Mass.; John McCain, R-Ariz.; Maria Cantwell, D-Wash.; and Angus King, D-Maine, have introduced their 21st Century Glass-Steagall Act of 2013. And, of course, there is the pending Volcker Rule's proprietary trading ban.
Seeking to narrow the range of activities in which well-capitalized and well-managed bank holding companies can engage is a mistaken endeavor. Activities in global financial markets that are outside the core of traditional banking did not cause the financial crisis. If narrow banking prohibitions are adopted at the holding company level, prohibited activities will be conducted by entities not subject to comprehensive consolidated supervision. Narrow banking will also lessen competition and thereby raise costs for end-users and customers.
The financial crisis teaches that it is the manner in which activities are managed, not the particular activities themselves, that causes risk. Mortgage lending is a traditional banking activity, which, if managed prudently, does not threaten an institution's balance sheet. When underwriting standards are radically lowered or ignored, however, mortgage lending like any traditional bank activity can produce losses and threaten failure. Of course, banks should not stop making home loans, or loans for commercial real estate development, another area of past danger.
There is no meaningful evidence that physical commodities trading had anything to do with the financial crisis. With ten years' experience, financial holding companies have shown that physical commodities trading risks can be managed consistent with Federal Reserve regulatory standards. The same is true for the investment banking activities that Warren's new Glass-Steagall Act would prohibit. There is no per se connection between new banking activities and inappropriate risk management.
Indeed, recent history tells us companies that are not regulated as financial holding companies are less likely to manage the risks from "financial-in-nature" activities appropriately. Lehman Brothers was, in essence, a standalone investment bank, as was Bear Stearns. MF Global was essentially a standalone commodities house. Such institutions are also more prone to runs because they have more volatile funding and cannot take insured deposits. Indeed, they and not universal banks are the poster children for institutions over-reliant on short-term market funding, which has recently become a systemic risk concern.
Portfolio diversification is a well-established, wise risk management strategy. Narrow banking ignores this concept, and is but one stage removed from the artificial limitations historically imposed by the federal thrift charter. With asset concentration mandated and diversification limited, thrifts were less able to respond to market downturns, and, no surprise, failed in both the 1980s and 2008.
Narrow banking will also drive prohibited activities into less regulated spaces. Ironically, it will return us to the pre-Dodd-Frank era, when institutions without a true consolidated supervisor AIG, Lehman, Bear Stearns took risks that proved destabilizing. Whatever Dodd-Frank's other failings, Congress did correctly perceive and address this issue, abolishing the Office of Thrift Supervision as a failed supervisor and giving supervisory authority over "securities holding companies" to the Federal Reserve.
Narrow banking will eliminate market participants and thus be anticompetitive. With fewer providers, customers and end-users will pay higher prices. Particularly when activities to be prohibited by narrow banking are financial in nature or have become intertwined with financial activities Bloomberg and CNBC refer to the commodity markets no differently than other financial markets there is no public benefit from artificially restricting competition.
There are still many ideas being considered on how to make the financial system safer: better and more consistent asset risk-weightings, higher leverage ratios, surcharges for systemically important financial institutions, limits on short-term funding. The costs and benefits of these ideas demand careful consideration, but narrow banking for bank holding companies should not be in the list. Subject to prudential supervision, well-capitalized, well-managed bank holding companies should be allowed to lean out into a range of financial activities not forced to lean in to narrow banking.
Arthur Long is a partner in the New York office of Gibson, Dunn & Crutcher LLP, a law firm with offices throughout the United States, Europe, Asia, the Middle East and Latin America.