Glass-Steagall: If Not the Cause, Maybe the Cure?

As the idea of bringing back some form of Glass-Steagall gains traction, the naysayers are coming out of the woods. How many are funded by the vested interests in the status quo is hard to say, but expect more of them. Last night there was one of the first forays, from the NY Times.

The idea of forcibly separating utility banking from casino capitalism has superficial attractions. The utilities, which would be tightly regulated, would focus on taking deposits and lending money. The casinos, which would be lightly regulated, could place bets on a range of assets. Paul A. Volcker, head of President Obama’s Economic Recovery Advisory Board, advocated some separation Friday at a conference at New York University’s Stern School of Business.

But Glass-Steagall would not have stopped the current crisis. For starters, many institutions that have had trouble were not commercial banks. Lehman Brothers, Bear Stearns and Merrill Lynch were investment banks; the American International Group is an insurance company. All four caused havoc when they teetered or, in Lehman’s case, collapsed. Any institution that is too big to fail, even if it is not in the utility end of banking, requires some sort of regulation.

Now, of course, lots of commercial banks have also gotten into trouble. Think of Citigroup or, across the Atlantic, the Royal Bank of Scotland or Switzerland’s UBS. One reason was that they invested in troubled securities. So it is appealing to think that they would have been safe if only they had not mingled the casino with the utility.

This again oversimplifies the issue... the solution is not to pick on one particular banking activity — like proprietary trading — label it as risky and quarantine it in some half-regulated purgatory. The better approach is to improve risk management across the industry.

Here is hubris. The author presumes that somehow animal spirits are going to be reined in by regulation or risk management as he euphemistically refers to it. We can have risk taking, innovation and profit or we can have state controlled enterprises, we can’t have both at the same time. They are mutually exclusive.

The point of reinstituting some form of Glass-Steagall is to bring the banks under the thumb of regulation as well as to reformat the banking industry. But we need risk takers as well and that function performs well only outside the realm of intense regulation.

The author is perfectly correct in asserting that Glass-Steagall, had it still been in force, would not have prevented the current crisis. But he misses the point as to why that would not have occurred.

It is not a function of a mixing of investment banking and commercial banking that brought us to this state of affairs, but rather our willingness to let financial institutions grow to monolithic sizes. The conundrum we find ourselves in is one in which we have become captives of financial institutions that overwhelm our capacity to shut them down and resolve the problems they have created. Resolve it we will, but the puzzle is how we prevent a recurrence of the problem.

A new Glass-Steagall that not only brings the commercial banks back to manageable size and complexity but also places the riskier elements of their activities off limits is one solution. We need the Goldmans (GS) and Morgan Stanleys (MS) of the world as well, but we need them in a form that causes little dislocation when they fail.

Defending failed policies and constructs is not going to provide a reliable framework for the future.

Comments

[nova:]

The major reasons for the present financial catastrophe are

- Both Clinton and Bush administrations that allowed
-- "Too big to fail" or Monopolies' creation(banking, Pharmaceuticals, defence, etc.,)
-- Corporate America bosses to loot their corporations and its shareholders without any restrain and complete impunity
-- "Casino Capitalism" with financial markets fraud, manipulation, and naked shorting

- The Congress by
-- Killing Glass-Steagall regulation
-- Forcing banking system into making loans for "social engineering" purposes instead of good business principles
-- Indiscriminately funding social programs without any intention to pay for them

- American taxpayers who allowed and supported the totally corrupt political system responsible for breeding parasitic and criminal social behaviors

Summary
1. One way or another, America will be force to move to the founding principals that made America great: Hard work and a truly free-market economy.

2. Social engineering with its "good" intentions has always failed since paving ways to Hell.

3. America must became once again highly a highly competitive nation.

Mar 09 02:46 PM

[Moon Kil Woong:]

With Glass Stegal in effect it would be doubtful banks could engage in CDS and other derivatives and also would be questionable if brokerages could tap banks money as easily as well as banks use brokerages to overleverrage themselves in risky vehicles. So in simple English, sure it would most likely have helped mitigate the vast excesses that lwed us to this crisis.

Arguments against is would have been:

Well if a foreign bank can mix the two asset classes everyone should. Well some banks in other countries never recognize real estate prices if it results in a loss. Does that mean we must as well. The easier answer to this is regulate their actions in the US.

Others would have been the Republicans passed Graham bill that allowed unregulated casino derivatives with a majority that even the president couldn't override by veto. So obviously then it would be hard to regulate anyone. And following with a Bush Jr. Presidency regulation would not have stopped anything because there was no regulation or enforcement. This is a good argument but also flawed. The recless flaunting of basic bank regulation would have brought red flags that the brokerage industry would not have. Bank regulation is much clearer about what can and can't be donew because to violate it puts the US taxpayer at imminent risk. No one could have known brokerages would do this as well.

Perhaps they wouldn't have if they were not allowed to feed on the capital assets of rotting corpses like Citibank for so long.

Anyway, arguing that no enforcement would have stopped this is like arguing that making laws is useless because there's not enough police. That still shouldn't stop you from making fair and proper laws.

Glass-Stegal was set up to prevent another Great Depression. In our folly, we chose to take the risk of reliving our past mistakes. Foolishness... Foolishness... Foolishness...


Constructe now known as Moon Kil Woong

Mar 09 03:09 PM

[Tesa:]

Nova, a good potion of what you say is valid but you are wrong in one aspect, in fact no one forced the banking system into sub prime loan making.

State governments were trying to halt the activities to protect their population but the banks were lobbying to nationalize and legalize the predatory lending. The did so for profiteering purposes.

In fact the sub-prime and predatory lending were anti-social and they were known to cause poverty because the financial institutions would try to extract more funds from those that couldn't afford it.

To top that off, many of these institution converted real estate to cash machine by allowing more and more borrowing against properties without any invested equity.

I hope you read this article to understand that there was no social engineering involved here but rather many mainstream banks were involved fraudulent practices to make more money.

www.cjr.org/the_audit/...

On Mar 09 02:46 PM nova wrote:
> -- Forcing banking system into making loans for

Mar 09 03:25 PM

[bcncv:]

The key problem is, and always will be, the limitations on risk management. As important as it is, risk management can generally only predict risk in markets that are behaving similar to the past. When the markets change, the models break down. If risk management were a perfect science, there would be no risk.

**I'm not saying this to absolve any of the incompetent risk management schemes out there, only recognizing the inherent limitations of the practice as a whole**

This is a problem that separation of banking functions might mitigate, but will not eliminate.

Here are several half-baked ideas that might make a real difference:

1. Require brokers of collateralized debt to insure the products they sell against losses above a certain threshold. Or require them to hold a percentage of what they sell. However it's structured, the underwriting agency must not be able to pass off all of the risk to unsuspecting buyers.

2. Implement margin requirements on derivatives contracts that are structured similar to the Fed's margin requirements on stocks.

Mar 09 03:54 PM

[ThatGuyInTh...:]

Any system designed to depend on self-regulation has already failed.

In a system driven by self-interest, gaming the system for one's own self-interest is the most rational thing to do.

Mar 09 04:19 PM

[akapital:]

You write:

"We can have risk taking, innovation and profit or we can have state controlled enterprises, we can’t have both at the same time. They are mutually exclusive."

This is not a factual statement but a matter of your personal philosophy and beliefs, and in my opinion it is a rather limited view point that the majority of people share; but that does not make it right. Moreover, I think this type of limited thinking is limited the type of solutions that are considered.

Of course you can have both.

Mar 09 04:20 PM

[Mashuri:]

akapital:

List some government controlled enterprises that turned a profit -- meaning, they were self-sufficient and did not have to rely on capital forcefully taken from the productive sector to operate.

Mar 09 04:29 PM

[bricki:]

Well I think you can find some things, like some municipally owned utilities that fit that description. However they only work if there there is no competition at all, and only seem like a competitive idea in comparison to heavily regulated monopolies.

I used to work for a company that was owned by the French government. What a nightmare. It was managed not for profitability but rather to maximize employment. FRENCH employment, so every time there was a layoff they would fire US workers and bring over expatriots to fill positions. The people that used to come over didn't want to be here. They smelled bad too. It is a fact that the French use less soap per capita than any other nation in Europe. And yes it was a soap company,

Notice I say USED to work for.

They eventually de-nationalized, and then the shit hit the fan. They sold off the good parts to the Germans, and the bad parts - well they sort of limp along. If it gets too bad I am sure they will get forced to merge with some other French company.

Nationalization, Been there, done that. Wouldn't advise it unless to somebody I didn't like. Economically it will crush any sort of efficiency or progress.

On Mar 09 04:29 PM Mashuri wrote:

> akapital:
>
> List some government controlled enterprises that turned a profit
> -- meaning, they were self-sufficient and did not have to rely on
> capital forcefully taken from the productive sector to operate.

Mar 09 05:22 PM

[bricki:]

There is a term I learned in college. It is "external diseconomy". What it refers to is a economic situation where a company is benefiting but the effects external to the company are harmful to the overall economy. Self-interest is serving the company, but not anyone else. One of the classical examples is pollution - a company just dumps its wastes to the environment because that is the cheapest thing to do. But of course sometimes these wastes can cause problems. Like Chisso-Minamata Disease.

When you have that sort of thing the situation needs to be restructured, be it regulation, taxation, etc.

What we have happening today is the result of an external diseconomy. Somebody writes loans, packages them up and sells the securities derived from the loans. Ooops loans go bad. Originator couldn't care less. Rating agency not liable for incorrect rating. Banking system goes tits up. BIG market crash.

There needs to be clawback to originator and rater for this stuff.

On Mar 09 04:19 PM ian807 wrote:

> Any system designed to depend on self-regulation has already failed.
>
>
> In a system driven by self-interest, gaming the system for one's
> own self-interest is the most rational thing to do.

Mar 09 05:35 PM

[Chris B:]

"This again oversimplifies the issue... the solution is not to pick on one particular banking activity — like proprietary trading — label it as risky and quarantine it in some half-regulated purgatory. The better approach is to improve risk management across the industry."
----------------------...
Yes, and our current deregulatory strategy has worked so well in the past 10 years! Alan Greenspan admitted that he was shocked that privately owned institutions could do such a poor job of managing risk for their own shareholders. It contradicted everything he had learned from Atlas Shrugged (guess what Alan, the executives made millions doing it and taxpayers ended up with the risk and losses).

Who do we expect to "improve risk management" in the absence of regulation anyway? Is risk riskier now than it was in 2005? Will no bubble inflate again because we're so much smarter now, after 3 bubbles in 10 yrs (tech, energy, real estate)?

How long did it take after the repeal of Glass-Steagal for the 2nd banking crisis since the depression to start? 8 short years. Just enough time to build Citigroup, BAC, JP Morgan, Bear Stearns, and AIG into casinos trading derivitives and mortgages.





"The author presumes that somehow animal spirits are going to be reined in by regulation or risk management as he euphemistically refers to it."
----------------------...
Right, and the market will naturally regulate itself. A few people still claim this is true, and have complicated narratives to blame their political adversaries. This occurred in the depression too.




"The author is perfectly correct in asserting that Glass-Steagall, had it still been in force, would not have prevented the current crisis."
----------------------...
It depends what you mean by crisis. Perhaps if Glass-Steagal had remained in effect, the investment banks still would have collapsed under the weight of their derivitives and credit default swaps. However, banks that do the commercial lending that is the lifeblood of our economy would still be lending and we wouldn't be facing a repeat of the great depression. Real businesses and consumers could still get loans. It would be a major Wall Street dislocation, but Main Street could survive.

A lack of loan availability is killing businesses and sending consumers to the unemployment lines. Mortgage unavailability is also driving the crash in housing prices. Ask your local realtor, auto dealer, or durable goods manufacturer.

Losing the investment banks wouldn't have been a crisis. Repeating the mistakes of the depression is!

Anyone who thinks reinstating Glass-Steagal would make our banks uncompetitive should consider the current situation. We're about to lose global dominance in finance.

Mar 09 05:40 PM

[Hillsfar:]

What's funny is how the government has allowed all the investment banks to become regular banks with FDIC-backing, and they've allowed GMAC to become a regular bank offerin' (a while back) 4.5% FDIC-insured CDs. If that's not pure anti-Glass-Steagal, I don't know what is.

Once the genie is out of the bottle, how would it get put back in? Then again, would having segregated types of banks really save people?

I think it makes more sense to not necessarily regulate, but make all information public. Use computerization to set up public databases of ALL derivatives and trading swaps that can be tapped into by not just government at the specific level, but also public researchers and investigators at the aggregate level. If AIG is backing $200 trillion worth of loans, and everyone knew, even if they didn't know who exactly, how many people would have gone into swaps with them?

Mar 09 05:44 PM

[Thomas J. G...:]

It makes sense to bifurcate the financial system into two pieces, "anything goes" and "takes retail investor money". I remember reading some big bank (i think it was jpm) was lending hedge funds money and I thought, "wow, the balances of a 100,000 checking accounts is being lent to a hedge fund. Maybe the bank somehow had collateral but it just seemed risky. The two types would be labelled clearly and if wealthy individuals wanted to invest in "anything goes", that's their business. But keep the two risk profiles separate and allow the "anything goes" style to go belly up without impacting ma and pa retail investor/checking account customer.

Mar 09 07:06 PM

[Between The...:]

Many ways in which public enterprise versus private corporations work that impede the ability of the public enterprise to make money. Here are some:

Governance: Shareholders directly elect the leaders of the corporation, versus the appointment (typically political) of the decision makers of public enterprise. If the shareholders dislike management's handling of the issues, they can vote the board out and replace them. Unelected political appointees can't be voted out, and the chain of responsibility leading to an elected official (say, your particular senator or rep) is very vague. It is very unlikely, even if one were to vote out the current politico, that the member of the other party that replaced him would somehow bring change to a specific inefficient bureaucracy with which the voter had taken issue.

Feedback: If a shareholder dislikes the way the company is going, he can always sell his shares to separate his personal financial interest from that of the company. He can even short if he dislikes the direction of the company that much. Can't happen with government enterprise as all tax-payers/voters are shareholders. Rapidly falling stock price is a clear signal to management and remaining shareholders that something is wrong - and history in this respect is clear that changes will be made or bankruptcy will await. There is no direct market for the actions of the government, and we have seen the willingness of the government to throw good money after bad.

Profit Taking: Well-run corporations generate profit for the financiers - this creates the incentive to have the corporation in the first place. A good idea plus hard work and savvy financing can make one rich. In the public space, the question of investment return isn't even asked. Investors can't withdraw their investment and place it where it makes a better return. In the public space, the budgetary process is one of trying to *maximize* spending in the current time-frame so that the next-year budget isn't cut (surplus is bad? In government, believe it). Management has no incentive to save or profit (no bonuses, no real tracking of metrics related to success) and any profits made would be consumed by other (loss-making) parts of the government instead of retained by the profit-maker.

Politics: This seems obvious, but when one compares the behavior of public investment to private, it is clear that many times the money goes to the politically expedient destination above all other concerns. When faced with two choices 1) allocate resources efficiently and fairly at the cost of votes and contributions or 2) put the money with the persons that maximize political and personal gain, and any rational person (not just straw-men politicians) will do what maximizes their benefit.

There are way more reasons, I was just trying to respond to a comment suggesting there was a way to have a truly-profitable public enterprise.

Mar 09 08:44 PM

[Nik Kondrat...:]

Regulation is needed. Glass-Steagall redux may help, but it is only part of the solution. We must bring naked OTC CDS's under regulation. That part of the shadow banking system is simply gambling. And even cities like Vegas an AC have regulations. It's completely insane that Greenspan and Rubin pushed Brooksley Born out of the CFTC when she was the lone voice calling for regulation of swaps and derivatives.

I know many people at ISDA who will fight against it, but frankly CDS's need it and naked OTC CDS's are the worst of the bunch.

Mar 09 08:52 PM

[User 354741:]

Chris B-

You pretty much have hit the nail on the head.

In the Glass-Steagall environment, the failure of a high proportion of depository institutions and subsequent drought in commercial lending would be a crisis (as it is now) but it would be almost certain that it would never occur to the extent that we now experience. The collapse of a major investment bank or even three or four, while unpleasant and certainly distressing and worthy of note, would probably not be a 'crisis' and would most likely be fifth-page news the day after.

One institution is legally constrained to be a low-risk enterprise with correspondingly low-return to depositors. The depositors trade high return for deposit security. They need secure credit lines for both personal and business reasons, and these institutions, by both law and charter, do not fund even the most credit-worthy of their clients without rigorous due diligence and hard collateral.

The other type of institution, the investment bank, exists to provide access to higher-return, high-risk funding vehicles of all kinds. The investors (not 'depositors'...investo... who board these vehicles usually have a more sophisticated financial mentality and training, higher tolerance for risk, more money, proportionally much less of their personal security to lose if an investment tanks....write it off and take a weekend in St Moritz to relax.

Personally, I don't believe that most people should even own stocks. Many, many of those baby-boomers whose accumulated paper gains have vaporized in this latest fiasco (often along with much of their principal) didn't even know what stocks their funds owned, didn't know what they were charged for 'services' every year by fund 'managers', and probably knew very little how to allocate their money or protect their principal.

Their deposits would have flourished in Glass-Steagall era bank 1, 3 or 5-yr CD's. Would they make the 20% per year that Bernie Madoff's clients thought they had? No, but they would have made 5%, made it regularly, and made it by virtue of their money being employed in interest on loans to commercial enterprises that actually create jobs and do real work.

Greenspan also forgot the component of political and economic liberty that truly corrupts the US economy, and that is the Federal Reserve and Fiat Money. That's for another rant...

On Mar 09 05:40 PM Chris B wrote:

> "This again oversimplifies the issue... the solution is not to pick
> on one particular banking activity — like proprietary trading — label
> it as risky and quarantine it in some half-regulated purgatory. The
> better approach is to improve risk management across the industry."
>
> ----------------------...
> Yes, and our current deregulatory strategy has worked so well in
> the past 10 years! Alan Greenspan admitted that he was shocked that
> privately owned institutions could do such a poor job of managing
> risk for their own shareholders. It contradicted everything he had
> learned from Atlas Shrugged (guess what Alan, the executives made
> millions doing it and taxpayers ended up with the risk and losses).
>
>
> Who do we expect to "improve risk management" in the absence of regulation
> anyway? Is risk riskier now than it was in 2005? Will no bubble inflate
> again because we're so much smarter now, after 3 bubbles in 10 yrs
> (tech, energy, real estate)?
>
> How long did it take after the repeal of Glass-Steagal for the 2nd
> banking crisis since the depression to start? 8 short years. Just
> enough time to build Citigroup, BAC, JP Morgan, Bear Stearns, and
> AIG into casinos trading derivitives and mortgages.
>
>
>
>
>
> "The author presumes that somehow animal spirits are going to be
> reined in by regulation or risk management as he euphemistically
> refers to it."
> ----------------------...
> Right, and the market will naturally regulate itself. A few people
> still claim this is true, and have complicated narratives to blame
> their political adversaries. This occurred in the depression too.
>
>
>
>
>
> "The author is perfectly correct in asserting that Glass-Steagall,
> had it still been in force, would not have prevented the current
> crisis."
> ----------------------...
> It depends what you mean by crisis. Perhaps if Glass-Steagal had
> remained in effect, the investment banks still would have collapsed
> under the weight of their derivitives and credit default swaps. However,
> banks that do the commercial lending that is the lifeblood of our
> economy would still be lending and we wouldn't be facing a repeat
> of the great depression. Real businesses and consumers could still
> get loans. It would be a major Wall Street dislocation, but Main
> Street could survive.
>
> A lack of loan availability is killing businesses and sending consumers
> to the unemployment lines. Mortgage unavailability is also driving
> the crash in housing prices. Ask your local realtor, auto dealer,
> or durable goods manufacturer.
>
> Losing the investment banks wouldn't have been a crisis. Repeating
> the mistakes of the depression is!
>
> Anyone who thinks reinstating Glass-Steagal would make our banks
> uncompetitive should consider the current situation. We're about
> to lose global dominance in finance.

Mar 09 11:54 PM

[tclwrap:]

sorry to say, we should have seen this one coming. We never learned from past mistakes, such as the dot com bubble. That makes 2 busts in less than a decade. Something is seriously wrong fellows...

Remember our reactions to the dot com bust? The CEO was held personally accountable for cooking the books, because of enron scandal. Now we have a totally unrelated issue, but it's effect is much bigger than enron. The real problem is, regulating after the harm is done is as good as no regulation.

Mar 10 12:12 AM

[johngonole:]

The solution is to protect the free market. These financial institutions were allowed to get way too large to the point that in some respects they controlled markets.

For starters lets take corporate greed. Whether you deposit you money at a brokerage, bank, Cd's, mutual fund etc.... The same people had your money.

So use the investor's mutual fund deposits to gain favor with board of directors by ALWAYS voting yes to outragous compensation packages. In return the BOD places IPO's, Bond offerings, etc with the investment bank in question.

Too big to fail is another reason they should never have been allowed to get so large. Moral Hazard is real. But it is self correcting in a free market. By Free market I do not mean anything goes. Markets are created by governments. Governments protect free markets by limiting control of price or supply by any one company or oligopoly.

Note that the small banks aren't having the kinds of problems that these large banks are having. Its pretty obvious that competitions and venerubility of free markets keep people honest or shuts them down. Its only these companies that became so large that they could purchase politicians and our tax money that the system broke down.

Regulation is only required from the standpoint of placing boundaries via law and enforcing them. We don't need the government intimately running operations. We need government to set a limit on how big finanical corporations in any line of business are allowed to get. We need government to break up brokers, banks, investment banks, insurance, into seperate task and not allow these companies to operate in all these different industries at the same time.

Mar 10 02:05 AM

[gu econ:]

Tell me how would Glass Stegall have prevented what has occurred:

1. Bear Stearns - an investment bank. Would GS its demise?

2. Fannie & Freddie - Regulated GSEs. Would GS have avoided the need to bail them out?

3. AIG - an inusurer - probably the most regulated of any financial industry in the country. Would GS have prevented AIG from underwriting CDS, the cause of their problems?

4. Lehman - Another investment bank. Same question as for Bear above.

5. Citi and all the other troubled banks. Would GS have prevented them from purchasing MBS and other toxic assets?

Regulators are like generals, fighting the last war. The problem was a speculative mania fueled by easy credit. That money is like a tide and would have found its way into something, and bureaucrats in DC would never have been able to stop it.

Mar 10 08:41 AM

[dtg:]

If originators of loans sold those loans to Freddie Mac or investment banks doesn't that take it off the books of the banks?
How does any bank have them on their books? As securities aren't these assets owned by investors? Shouldn't the owner of these assetes bear the risk of market prices?
Did banks buy these assets for their own accounts?

Mar 10 08:58 AM

[Tesa:]

"gu econ", yes it would have prevented it in fact. Many of the institutions that had purchased CDOs were regular banks who insuring high risk CDOs with an institution that insured banks and these high risk activities. There would have been no intermingling if the act was there. The act would have disallowed that.

The moral of the story is that low risk assets should not be used to insure high risk assets; at least not being hedged and the hedging requires fairly regulated body that does not cheat. Glass-Steagall is just one act that could have interfered with that process but there are others that could have replaced it but what was the replacement!.

Just think about it, imagine someone uses their house as collateral for gambling. Only the paid portion can be used as collateral otherwise other people will hold the bag for the gambler. If the house is mortgaged, its peak value should not value as collateral. Another way is o hedge against the loss of its market value when its used as collateral. The hedge should not be devised fraudulently and that means that the gambler can not do the hedging or use other gamblers to do the hedging in collusion.

Mar 10 09:51 AM