Glass-Steagall Act Repeal Did Not Cause The Great Recession

Includes: BA, C, JPM, WF
by: Martin Lowy

The other day, a commenter asked me to explain why I thought the repeal of much of the Glass-Steagall Act by the Gramm-Leach-Bliley Act in 1999 did not contribute significantly to the occurrence of the Great Recession. I had excised that discussion from the article on the ground that I thought it interfered with the real point of the article, which had to do with what the new French president, M. Hollande, might want to accomplish in the banking sector.

What Glass-Steagall Said

What was Glass-Steagall? It was four sections of the Banking Act of 1933: Sections 16, 20, 21 and 32.

Section 16, codified as paragraph seventh of section 24 of the National Bank Act, applied solely to national banks and Federal Reserve System members. It said two things: One, such banks could invest only in debt securities (no equities)-and only in such securities that were authorized by the Comptroller of the Currency, which is the supervisor of national banks. Securities authorized by the Comptroller were defined as "investment securities", and in practice the Comptroller restricted such securities to investment grade securities. Two, no such bank (national bank or Federal Reserve member bank) could (except for investment securities as defined above) deal in securities or stock for its own account, but could do so solely upon the order of and for the account of customers.

Section 20 said that no member bank of the Federal Reserve System (which includes all national banks) could affiliate in any way with a firm engaged in securities underwriting.

Section 21 applies to any institution that accepts "deposits". It prohibits any such institution from underwriting securities. [Section 21 has not been repealed. Bank holding companies underwrite through non-bank affiliates.]

Section 32 prohibited interlocking directorships between member banks and underwriters.

Interpreting Glass-Steagall

Of course there were court cases, regulations and commentary that interpreted these provisions. Beginning in the early 1980s, the regulations and administrative interpretations carved out significant exceptions to what many had thought were the prohibitions of Glass-Steagall. These interpretations permitted securities brokerage operations for clients and even permitted limited underwriting of securities by what became known as "Section 20 affiliates". But it was not until the creation of CitiGroup in the late 1990s that the more fundamental strictures of Section 20 were challenged, resulting in the passage Gramm-Leach-Bliley in 1999 that more or less repealed Section 20.

Impact of the Repeal on The Great Recession

I see no evidence that the repeal of much of Glass-Steagall in 1999 was a significant cause of the 2003-2007 boom or the subsequent Great Recession that the boom led to. The combination of investment banking and commercial banking did not cause-or even really exacerbate-the Great Recession.

First-off, the boom was created by real estate lending-real estate lending in America, U.K., Spain, Ireland, Iceland, and elsewhere. That real estate lending helped to push up house prices that already had appreciated significantly in the 1990s. Higher house prices led to consumers stripping large amounts of equity from their homes and spending it on all sorts of things. In America, the equity extraction exceeded $1 trillion. That spending added that $1 trillion, plus a multiplier, to U.S. GDP. When combined with spending on the Iraq and Afghanistan wars, something like $2 trillion was added to GDP. Without these additions, there would have been no (probably negative) GDP growth in the apparent boom years of 2003-2007. Thus the boom always was illusory.

But did the repeal of parts of Glass-Steagall materially add to the real estate lending or the war? I assume that I am on safe ground in asserting that it did not cause the war. I will assert that it did not cause the real estate lending, either. The companies that were at the heart of the real estate lending machine were predominantly not companies that were engaged in both commercial and investment banking. The bulk of the lending was done by companies like Countrywide, Washington Mutual, Indy Mac, Fannie Mae, Freddie Mac, and the dozens of smaller specialized subprime lenders that were neither commercial banks nor investment banks. [Yes, F&F do not lend but they set the underwriting standards and guarantee, thereby effectively lending.] The smaller mortgage companies sold the loans they made either to F&F or for packaging and sale into the securities markets, as they always had done. Washington Mutual and Indy Mac kept a lot of their production in their own portfolios. The companies that packaged the securities included some commercial bank/investment bank combinations, notably Citigroup. But Goldman Sachs, Bear Stearns, Lehman Brothers and Merrill Lynch, which together accounted for most of the privately issued [non-F&F] packaged loans sold as securities, were not commercial banks at all. European banks that participated, such as Barclay's, were universal banks before 1999. AIG, which enabled some of the worst securities by writing CDSs, was neither a commercial bank nor an investment bank.

The banks that failed were either thrifts/mortgage banks without investment banks (e.g., Countrywide, Washington Mutual and Indy Mac) or investment banks without commercial banks (e.g., Bear Stearns, Lehman Brothers and-nearly-Merrill Lynch). AIG was neither. F&F were neither. Some of the European banks that got bailed out had both investment banks and commercial banks, as did Citi (NYSE:C), which also got bailed out, but in each of the cases, with the possible exception of Citi, I can find little about the combination of investment banking and commercial banking that led to the failure. The German Landesbanks, the U.K. bank Northern Rock that was an early poster child for the crisis, and the Spanish cajas that are still bedeviling the Spanish economy had no investment banking capabilities. The Spanish cajas were just thrift institutions without either real commercial banking or investment banking. Like Northern Rock and the cajas, the Irish banks and Icelandic banks failed the old fashioned way-by making bad loans. UBS (NYSE:UBS), which had to be bailed out by the Swiss government, bought a lot of bad CDOs-but that was purely a banking arbitrage that had nothing to do with trading or investment banking.

The Volker Rule

Perhaps the assertion that Glass-Steagall caused the Great Recession is borne of political nostalgia. The left lost the Glass-Steagall legislative battle and would like to reverse its loss. One of my friends even penned a song "Bring Back Glass-Steagall Again", to the tune of Gene Autry's "Back in the Saddle". But in the one important respect, the left has reversed its loss because the Volcker Rule, which outlaws proprietary trading by commercial banks although proprietary trading had little to do with the Great Recession, will scale back risky activity that, arguably, was not permitted by Section 16 of Glass-Steagall.

Instituting the Volcker Rule to restrict proprietary trading should not, however, conceal the historical fact that the underwriting securities offerings is not very risky. Lending is far riskier than underwriting. The old investment banking partnerships were not lenders. There was little income and much risk in lending. An underwriter closed the deal after having it sold, held the goods for a few days and closed with buyers at a significant profit. Three percent on one's money, for example, when the money is at risk for an average of less than a week, is nice business. Corporate advisory business, often a handmaiden of underwriting, similarly, has little risk. Trading, on the other hand, is, like poker, by definition a zero sum game. If you know who the pigeons are, it makes sense to play. But otherwise it is risky, since if you do not know who the pigeons are, maybe you are one of them.

I would argue that proprietary trading is not investment banking. It is more akin to market making, which once was the province of a special cast of dealers and NYSE specialists. Bond markets were opaque to outsiders to the dealer club. Therefore the dealers could make money buying and selling bonds to investors who had nowhere else to go. A dealer could take a position in a bond practically (sometimes actually) knowing where it could be disposed of at a profit. And the early bond traders merely broadened that market.

Investment bankers who were at Lehman Brothers and Salomon Brothers in the late 1970s probably would agree with my assessment of trading from their personal experience. The traders took over those investment banking firms, and though trading was, for a time, very profitable, it eventually led to problems that caused both firms to be acquired by larger, less risky institutions.

If we define investment banking as securities underwriting, corporate advisory business, including M&A advice, and securities brokerage on behalf of customers, it is hard to see why such business is not less risky than commercial banking rather than more risky. For that reason, separating investment banking from commercial banking on the ground that it endangers the commercial bank, quite frankly, makes no sense to me.

I wonder, based on a mistake made in and S.A. article , whether those who call for reinstituting Glass-Steagall might not be referring to the Bank Holding Company Act (of 1956 and much amended) prohibition against bank holding companies (companies that own or control one or more banks) owning or controlling companies engaged in any but bank-like activities.

Clash of Cultures

It is said in some circles that the clash of cultures between investment banking and commercial banking is an inherent problem. Investment bankers, it is said, take more risk and are paid more. If traders are investment bankers, then I agree that they are, by their nature, a riskier bunch. But I think the advisory and underwriting people are not. The pay issue, however, is quite real. But that looks to me like a management issue. Why should regulation have to deal with that? That is the job of the board of directors. If the board cannot profitably rationalize the pay scales, then the board should reorganize the company. If boards constitutionally cannot deal with such issues, then society should re-think the way corporations are governed.

Banks Are Too Big

Some people apparently see the repeal of Glass-Steagall as the reason that banks grew so much over the decade of the 2000s. They say that the enormous size of American banks today (NYSE:A) gives them too much political power, (NYSE:B) makes them too hard to manage, makes them too big to fail, and (NYSE:D) gives them the power to fix rates and other terms of service. All that may be true. But the current size of America's large banks resulted from mergers among banks, either voluntary or forced after failures, not from the consolidation of investment banks and commercial banks. JPMorgan Chase (NYSE:JPM), for example, is an amalgamation of something like ten banks that were, on their own, major banks a generation or so ago-and of dozens of banks, if we count all those that were independent in 1980. Bank of America (NYSE:BA) and Wells Fargo (NYSE:WF) have similar lineage. Thus, although size may be a problem, reviving Glass-Steagall would not be the answer.

Disclosure: I am long JPM.