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While watching CNBC this morning, I noticed something interesting in the message Sanford Weill , the 'one-time poster boy' for creating bank supermarkets (as noted by former FDIC Chairperson Sheila Bair), was conveying during his interview. He essentially called for the return of the Glass-Steagall Act of 1932, which imposed banking reforms that split banks from other financial institutions such as insurance companies. The conversation revolved around the repeal of the Act, which prohibited commercial banks from acting like investment banks, by taking on much greater risk. Although there are those who will dispute it, there is little doubt that this drastic climate change in contributed to the financial meltdowns of recent years.

The Result of Repealing Glass-Steagall

Banks traditionally accepted deposits and made commercial and real estate loans. Their capital came primarily from investors and accumulated retained earnings. On the contrary, investment banks were funded primarily from the partners' own money in addition to the funds provided by clients obviously creating an atmosphere of conservatism in their investment portfolio. Risks were limited to those agreed upon in such activities as daily directors meetings.

With the demise of Glass-Steagall, and the resulting combination of commercial and investment banks, brokers now had access to public money from investors which, as opposed to conservatism, created the 'Wild West' atmosphere that resulted in these calamitous financial meltdowns. For example, the availability of these funds allowed for the catastrophic losses that JPMorgan Chase (NYSE:JPM) incurred as a result of Bruno Iksil's well documented trading activity.

While some may argue, and with some validity, that the housing market debacle resulted from lending based upon the virtually non-existent borrower's credit criteria, the proliferation of such practices was only made possible by the investment banks creation of CDOs and CMOs, thus providing unlimited funding for the sub-prime mortgage industry. Many of the investment banks who previously engaged only in traditional retail and commercial banking such as Bank of America (NYSE:BAC), Citigroup (NYSE:C), Bank of New York Mellon (NYSE:BK), Wells Fargo (NYSE:WFC), and JPM used these subprime CDOs and CMOs to create a financial revolving door consisting of virtually worthless products.

Why We Should Reinstate Glass-Steagall

There are several reasons why we should reinstate the Glass-Steagall Act of 1932.

The primary reason for reinstatement is the restoration of public confidence in a damaged banking industry. As opposed to the sentiment surrounding the big banks, the public support and confidence for such regional banks as New York Community Bank (NYB), CVB Financial Corp. (NASDAQ:CVBF), and Wintrust Financial Corp. (NASDAQ:WTFC) has certainly not diminished as much as it has for names like Bank of America, Citigroup, Wells Fargo, and JP Morgan Chase.

Secondly, the big banks need to have a greater sense of regulatory compliance. Currently, and because they operate in the dual capacity of a retail and investment bank, they are not subject to the Volcker Rule, which restricts US banks from making certain types of speculative risk investments. If banks were to split their retail and investment operations, the retail side would be subject to such regulatory compliance and if losses were to occur on the investment banking side they wouldn't interfere with the operations of the retail banking side.

As noted in my argument for the reinstatement of the Glass-Steagall Act of 1932, I highlighted the fact that the regional banks have outperformed the big banks over the last five years. That said, and after using the 5-year total return statistics as provided by Ycharts.com, the 5 Big Banks have demonstrated an average 5-year total return of -46.09% and the 3 Regional Banks have demonstrated an average 5-year total return of 14.50%.

Conclusion

In conclusion, I find it very interesting that Mr. Weill has reversed his original position, and is now calling for the breakup of the big banks, in conformance with the requirements of the original Glass-Steagall Act. His comments are certainly the talk of the town amongst both investment and financial professionals. However, it is obvious that this is not the end of the story and the dialogue is bound to continue for months to come.

Source: Glass-Steagall: Why We Shouldn't Fix Things That Aren't Broken