There has been a lot of talk lately about the repeal of Glass-Steagall in the 1990’s and the potential that such a move contributed greatly to the financial crisis. Glass-Steagall, originally passed in 1933, had many parts to it but it is most widely known to have disallowed commercial banks that gathered customer deposits and gave out loans from also being investment banks that would underwrite securities and trade for their own account.
The logic of Glass-Steagall makes sense: banks should not use depositor or government capital to fund internal hedge funds. Should the enormous risks the trading desks take turn sour, it puts customers’ deposits in jeopardy and reduces the amount of lending the firm can do. Not to mention the fact that cheap government funding is given to banks to boost lending and the economy, not to generate trading profits for the firm’s partners.
Despite the soundness of the law, those who maintain that the repeal of Glass-Steagall was a leading contributor to the financial crisis are off base. Why? Because most of the casualties of the financial crisis were not banks at the time. Off the top of my head I can name AIG (AIG), Fannie Mae (FNM), Freddie Mac (FRE), Lehman Brothers, Bear Stearns, and Merrill Lynch.
None of those firms were commercial banks but they lost the most money. Those losses came from poor mortgage underwriting, poor insurance underwriting and extreme leverage ratios of up to 40-to-1. More effective government regulation surely could have helped prevent such monumental downfalls (minimum underwriting standards and leverage limits to name a couple), but a combination business model of commercial and investment banking was not the culprit by any stretch of the imagination.
Now there were commercial banks that failed or nearly did during the recent crisis. Wachovia and Citigroup (C) are the two big ones. But again, Glass-Steagall would not have prevented this. Citigroup was hampered by its leverage and significant holdings in mortgage backed securities, CDOs and SIVs. Wachovia failed after it acquired a California-based mortgage lender that pioneered interest-only, pick-a-payment and option ARM mortgage products. Such poor, undocumented, mortgage underwriting doomed them from the start, not investment banking (Wachovia did little, if any).
I am all for better regulation of the financial services sector, but many of the ideas floating around do not really address the core issues the industry faces. Not only that, existing regulators and laws easily allow for better regulation, without further changes, even though modern products such as credit default swaps and futures contracts clearly need to be regulated going forward.
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