The Fed and a return to banking simplicity
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With so much to occupy our attention this electoral season — border walls, "basket of deplorables," small hands, walking pneumonia — you'd be forgiven for overlooking a wonkish report put out jointly last week by the Federal Reserve Board (the "Fed"), the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC).

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Yet this document is probably the most important development in regulatory attitudes toward our financial system since the Dodd-Frank Act of 2010, if not the Gramm-Leach-Bliley Act of 1999. It is also an object lesson in the good that careful scholarship can do — and the ill that sloppy scholars can do.

For present purposes, I'll limit myself to the Fed's portion of the report that I have in mind, leaving the FDIC's and the OCC's portions for later. In its portion, the Fed recommends that Congress, among other things, repeal certain special privileges that it conferred upon large financial conglomerates via the aforementioned Gramm-Leach-Bliley Act of 1999 — privileges that have constituted nothing less than a quiet scandal over the past 17 years.

Let me first say a bit about the Gramm-Leach-Bliley Act, which is what brought us these financial conglomerates in the first place. Then I'll say more on those scandalous privileges that it also conferred upon them.

The Gramm-Leach-Bliley Act, pushed by then-Fed Chairman Alan Greenspan and then-Treasury Sec. Lawrence Summers and signed into law by President Clinton near the end of his presidency in late 1999, is probably best known for its partial repeal of the Glass-Steagall Act. That was the post-1929 legislation which prohibited federally insured depository institutions from affiliating with speculative securities firms and insurance companies under single holding company structures.

But Gramm-Leach-Bliley did more than that. It also permitted conglomerates owning depository institutions to own merchant banking firms — think private equity — and physical commodity trading houses, as well as hedge funds and other derivatives trading entities.

In essence, then, Gramm-Leach-Bliley removed or dramatically lowered nearly all of the previous century's barriers between Main Street depository banking institutions — the ones that hold your and my deposits, constitute our national payments system, and are in consequence insured by your and my government — on the one hand, and high-rolling Wall Street speculator institutions on the other hand.

Now lest we forget, these barriers had originally been put in place for a multitude of reasons, each of them compelling in its own right. One reason was to limit the risk-exposure of depository institutions in which Mom and Pop kept their hard earnings, on which all of us depend for the making of payments, and which Uncle Sam in consequence guaranteed and in that sense thus subsidized. A related reason was to limit the cheap (government-guaranteed) funds available to speculative investors whose activities tend to inflate asset price bubbles. A third reason was to limit the complexity of financial institutions, which can quickly become ungovernable even by their own officers and directors, let along regulators, when their operations become too multifarious and far-flung.

A fourth reason for the old regime was to maintain market integrity, which is easily compromised when too few firms control too much finance — or when the same entity that places bets upon, for example, commodity price movements through its derivative trading operations also controls those commodity price movements itself through a commodity trading house. (Yes, you can attempt to maintain "firewalls" between such operations in-house, but these never withstand profit-promising fire.)

And finally, a fifth reason was to maintain a level playing field among non-financial firms operating in the "real" economy, since firms of that sort held by financial conglomerates always enjoy unearned funding advantages.

Each of these reasons, as I said, was compelling in its own right. And so Congress and our principal financial regulators sought to include safeguards in the Gramm-Leach-Bliley regime meant to respond to them, thereby enabling us to have our cake and eat it, too. The problem, as many (including the Fed) are now coming to recognize, is that these safeguards have proved not safe enough.

The first indication, of course, was the sequence of asset price bubbles, followed by busts, we experienced early on in the new Gramm-Leach-Bliley era. A host of speculative entities, newly affiliated with large depository institutions holding huge federally insured deposit bases, had pumped unprecedented quantities of asset-price-inflating credit into the economy. (It's still happening, by the way.) This of course culminated in the crash of 2008-2009, which threw millions out of their jobs and their homes and cost billions of dollars in public bailouts of failing private financial institutions.

Nearly as soon as we came to understand what had happened in the lead-up to that crash, it also emerged that those in charge of the new conglomerate institutions — not only their regulators, but even their own officers and directors — were simply unable to keep track of their sprawling and ultimately destabilizing operations. Indeed, we soon learned that this incapacity had not only played a critical role in enabling the bubbles and busts of the decade following passage of Gramm-Leach-Bliley, but also lay behind a host of new, post-crisis market-manipulation abuses. These commenced with the "London Whale" LIBOR-fixing scandal discovered in 2012 and were quickly followed by remarkably similar EURIBOR, foreign exchange, precious metal, and commodity price-fixing scandals in the immediately ensuing years.

Probably the most attention-grabbing discovery of all made in the post-crash period, however, was that of Professor Saule Omarova, then of the University of North Carolina School of Law. Omarova learned that three of the largest financial conglomerates that Gramm-Leach-Bliley had enabled to come into existence — Goldman-Sachs, JP Morgan and Morgan-Stanley — had become huge, market-dominant players in the world's physical commodities markets.

These institutions, in other words, were not only speculating in financial markets with the benefit of other people's [i.e., bank depositors'] money, but also were moving the prices of aluminum, petroleum and a host of other physical commodities on which all of us depend. In addition, through their derivatives trading activities, they were able actually to "bet" on the prices of these items whose prices they ultimately controlled, and of course were exposing themselves to the liability risk to which, e.g., environmental disaster in some of those markets — for example, that for petroleum — could give rise. A more dramatic challenge to all five of the policy concerns noted above to have animated the pre-Gramm-Leach-Bliley regime, and which Congress and our regulators had tried to continue to vindicate by other means in the Gramm-Leach-Bliley regime itself, could scarcely have been imagined.

Omarova's research led to a flurry of journalistic, Congressional and ultimately federal investigations. It even caught the attention of the then-guest host of "The Daily Show," John Oliver. Financial writers devoted high-profile newspaper stories and even book chapters to Omarova's discoveries. The Senate held two separate hearings at which she testified. Finally, the Fed solicited public comment on how, if at all, it should respond to these findings — a solicitation that brought detailed recommendations from Omarova herself, from this columnist, from Sens. Sherrod Brown (D-Ohio) and Elizabeth Warren (D-Mass.), then-Sen. Carl Levin (D-Mich.), and from many public interest organizations, including Americans for Financial Reform.

Which brings us to the Fed's recommendations of last week. As noted above, Gramm-Leach-Bliley not only enabled sprawling financial conglomerates to form in the first place, but also conferred upon some of them certain special privileges that subsequently proved ill-advised. These both enabled some of the commodities trading activities that Omarova brought to light and enabled some firms to do more of it than others.

One such privilege was the so-called "merchant banking" authority, pursuant to which large financial conglomerates are permitted to own non-financial firms, including commodities trading houses, outright or through private equity affiliates. This is clearly one avenue through which what you thought was your bank can also amount to a petroleum-trading company. The other such privilege was the so-called "grandfathering" provision, pursuant to which any firm that had a hand, how ever small, in physical commodities before Gramm-Leach-Bliley could now, after Gramm-Leach Bliley, confer large-scale involvement in the physical commodities business upon a financial conglomerate of which it became part.

These two privileges are among those the Fed is now recommending that Congress rescind. In so doing, it has concluded that these were experiments that have failed and is recommending, after literally years of careful study, a partial restoration of that simpler, less systemically risky and less corrupt financial system we had before Gramm-Leach-Bliley. Perhaps unsurprisingly, Omarova, whose careful investigations ultimately led to these recommendations, has applauded them. More surprisingly, however, another legal academic now has also weighed-in — this time, with none of the meticulousness that one finds in Omarova's work.

In a recent New York Times column, Professor Steven Davidoff Solomon of the University of California, Berkeley School of Law accuses the Fed of "proposing to ban" merchant banking, asserts that the Fed's motivation is a "'take no risk' regulation strategy" and then faults the Fed for not quantifying the risk he asserts is its sole concern. He also patronizingly suggests that the Fed "would be given an 'F'" by any professor of a basic corporation law class for suggesting that a bank conglomerate might face liability risk were a firm it controls to cause an environmental disaster, and chides the Fed for engaging in nothing more than what he calls "bank-shaming."

As is readily appreciated in light of the above, not to mention in light of the Fed’s actual words in the report, this is all shoddy opining at best, disingenuous at worst. The Fed has not "proposed to ban" merchant banking; it has simply proposed that merchant banking once again be done by merchant banks — that is, by private equity firms rather than by the depository institutions that constitute our payments system, in which you and I keep our hard earnings for safekeeping, and which our federal government in consequence insures.

Likewise, the Fed has not based its recommendation on a "take no risk" regulation strategy; read its report, and you'll see at once that its concerns amount to the full panoply of those I elaborated above — those that both animated the pre-Gramm-Leach-Bliley regime and were meant to continue to be vindicated, but have proved not to be vindicatable, in the new Gramm-Leach-Bliley regime itself. Finally, as for the Fed's supposed "F," it would seem that the "basic corporation law" professor would do well to dust off his casebooks or perhaps go back to school with Scott Alvarez or Dan Tarullo; for, as the Fed itself notes in its portion of last week’s Report, it is quite well-established that actively controlling the daily operations of the incorporated firm in which you purport only passively to hold shares can take you out from behind what you thought was your ‘limited liability shield.’

What then is left of the pseudo-attack on the Fed? Maybe the "bank-shaming" charge sticks? Nope. Here too there is nothing, literally nothing, in the Fed's portion of last week's report that looks to be prompted by any such motive. Nor need there be. For in their continuing demands that we the public continue to subsidize their private bubble-blowing, systemic risk-raising, market-manipulating and trade-restraining activities via their Gramm-Leach-Bliley-enabling affiliations with our federally insured depository institutions, the financial conglomerates are doing a fine job of shaming themselves.

Hockett, a regular contributor to The Hill, is Edward Cornell Professor of Law at Cornell Law School, senior counsel at Westwood Capital and a fellow of the Century Foundation.


The views expressed by contributors are their own and not the views of The Hill.