Reviving Glass-Steagall: A solution in search of a problem
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D.C. denizens agree on few things these days, but one thing has achieved considerable bipartisan support: a revival of the Glass-Steagall separation of commercial banking from other activities, including investment banking. When Bernie SandersBernard (Bernie) SandersDe Blasio headed to Iowa to speak at political fundraiser Yes, spills happen — but pipelines are still the safest way to move oil Why sexual harassment discussions include lawmakers talking about Bill Clinton’s past MORE and President Trump and ex-Goldman Sachs president (and current Trump Chief Economic Advisor) Gary Cohn agree on something, it must be a good idea, right?

Not so fast. Breaking up banks along the old Glass-Steagall lines is a solution searching desperately for a problem. One tell is the fact that the 1933 rationale for the separation of commercial and investment banking is completely different than the rationale given today: when a certain remedy is recommended for everything that ails you, it is more likely to be nostrum than cure.

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The justification for the separation given in 1933 was that banks were fobbing off bad loans that they had made onto unsuspecting bond buyers by packaging them into securities and underwriting them through their investment banking arms. Alas, academic research has demolished this story. Bonds underwritten by the investment banking arms of universal banks were of higher quality than those underwritten by stand-alone investment banks.

 

Today’s justification for Son of Glass-Steagall is completely different: specifically, it is that the repeal of the original in 1999 under the Gramm-Leach-Bliley Act was a major contributor to the Great Financial Crisis of 2008, and that its restoration would reduce the likelihood of future crises.

This is a great distortion of history. Stand-alone investment banks—notably Bear-Stearns and Lehman Brothers—were the first and biggest to fail, in part because of their reliance on funding from the market instead of “stickier” deposits that commercial banks can utilize. Indeed, the Federal Reserve’s main response to the difficulties of investment banks was to arrange shotgun marriages with commercial banks: this failed in the case of Lehman when the intended groom—Barclays—ran for the hills. It also allowed surviving investment banks to become commercial banks, so they could take advantage of the Fed’s support.

Furthermore, other major entities that were at the epicenter of the crisis were not universal banks. Fannie and Freddie were GSEs. AIG was an insurance company. Countrywide, IndyMac, and WaMu were S&Ls that specialized in mortgage lending. The root of the financial crisis was credit losses on real estate loans, and this had precious little to do with the elimination of Glass-Steagall separations nearly a decade before.

The current enthusiasm for Glass-Steagall separations appears to be nostalgia, combined with a desperation to find a way of preventing future crises. The heyday of Glass-Steagall from the end of WWII through the 1960s was a period of financial quiescence (by historical standards), and there is some hope that we can recreate this placidity by restoring the specialization of financial companies. However, this happy time was the product of unique post-war conditions, and various forms of financial regulation (and financial repression) that were unsustainable. Indeed, a primary reason that Gramm-Leach-Bliley was passed was that clever financiers were finding ways to innovate around Glass-Steagall restrictions, meaning that they were increasingly irrelevant.

The trauma of the 2008 crisis has understandably motivated a search for ways to prevent a repeat, but this has been very frustrating given the complexity of financial markets. There is a broad sense that something needs to be done to rein in banks, and make them smaller, and this makes a resurrection of Glass-Steagall superficially appealing even if a deeper analysis casts serious doubt on the efficacy of such an action.

The skepticism of just-departed Federal Reserve governor Daniel Tarullo regarding the part of Dodd-Frank intended to be Glass-Steagall light—the Volcker Rule limiting proprietary trading by banks—is telling. Tarullo is hardly a regulation skeptic or a banker’s buddy: indeed, he was considered the industry’s scourge. But in his valedictory remarks he suggested the rule was too complicated, was having deleterious effects on markets, and that more capital and better risk-based capital requirements were likely preferable. 

Tarullo’s observation gets to the heart of the issue, which is how to constrain risk taking by financial firms. Structural measures—like Glass-Steagall or the Volcker Rule—try to do this indirectly by constraining the activities that certain firms can engage in. But this can simply result in a shifting around the risk, and the narrower firms (e.g., stand-alone investment banks, AIG) that bear it can pose serious systemic risks. Furthermore, even banks engaged almost exclusively in commercial lending can create systemic risk: recall that the phrase “too big to fail” was coined to describe banks like Continental Illinois that took big loan bets that went bad while Glass-Steagall was operative. 

More capital and better risk adjustment of capital requirements have many advantages over structural measures as a way of disciplining risk taking by financial firms. Moreover, a case can be made for revisiting another, and heretofore sacrosanct, part of Glass-Steagall: government deposit insurance.

Craig Pirrong (@StreetWiseProf) is a professor of finance at the University of Houston’s Bauer College of Business. He has published 30 articles in professional publications and is the author of three books. His consulting clients have included electric companies and commodity firms around the world.


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