Glass-Steagall 3.0: A Modest Proposal

 |  Includes: AIG, KBE
by: Cam Hui, CFA

The stock market has been spooked by Obama’s Volcker plan to limit banking activities. Moreover, there have been trial balloons floated regarding the reinstatement of the Glass-Steagall Act, legislation that separated commercial and investment banking activities.

Time for Glass-Steagall 3.0?
Is that enough?

Any legislation overseeing financial activities should have the following purposes:

  • Eliminate or reduce the number of “too big to fail” (TBTF) institutions.
  • If there were TBTF institutions, the downfall of one shouldn’t bring down the system.
  • At the same time, it should also allow financial institutions the room to compete effectively in the marketplace.

I have a modest proposal that will meet most of those multi-purpose objectives. Let’s call it Glass-Steagall 3.0. I'll start with the old Canadian model, where financial institutions were broken up into four distinct categories: banking, trust, insurance and investment banking and companies that were in one business were not allowed to be any other. This effectively breaks up large financial conglomerates and reduces their size and therefore their TBTF risk. If you agree with Paul Volcker’s contention that the greatest financial innovation has been the ATM, then breaking up financial conglomerates should not reduce value because of the removal of “synergy”.

Add to that, implement my proposal for bringing back the partnership investment bank, or at very least, do not allow investment banks to be publicly traded. If an investment bank were to be a privately owned limited liability corporation, most of the personal net worth of management is likely tied up in the illiquid shares of the company. Such an arrangement focuses the mind on risk management, not short-term profits.

Nothing is perfect
This plan isn’t perfect. It wouldn’t have prevented AIG from imploding. On the other hand, if investment banks had greater risk controls in place, the size of the mortgage market wouldn’t have gotten to the size that it did. Consequently, the size of the AIG book wouldn’t have grown to the gargantuan size that it did and the spillover effect into the investment banking system could have been contained.

Another drawback is that the small size may hamper the ability of some of the smaller financial institutions to compete effectively. Stanley Hartt, who was Canada’s Deputy Finance Minister (the most senior bureaucrat in the “apolitical” civil service), commented that Canada dismantled the four pillars approach to financial regulation because it found that there were a number of small regional bank failures because they were too small and had an overly undiversified asset base to compete effectively.

Pick your poison
There is a classic line from the original Star Trek series:

Spock: The guilty party has his choice-- death by electrocution, death by gas, death by phaser, death by hanging...
(see sequence from about 3:55 below)

Would you like a financial system that bends like a willow tree with the wind (Glass Steagall 3.0)? Or would you like one that is strong but brittle (the current system)?

Personally, I would prefer to live with small bank failures, i.e. a system that fails in small pieces but gracefully, than with a large monolithic one that is brittle and breaks without warning.

Pick your poison. Death by electrocution, gas, phaser...