Time To Move On (Again) From Glass-Steagall: Part 2
By Norbert Michel, Heritage Foundation financial regulations expert
The 1933 Glass–Steagall Act is widely viewed as a law that ended overly risky financial practices that led to the Great Depression. It’s a great reputation, but not deserved.
Glass-Steagall was, in fact, a triumph of smart politics over sound policy. Inspired by America’s historical mistrust of banking and so-called speculative investing, its terribly designed rules and regulations continued the long line of bad policies that produced one of the most fragile banking systems of the developed world.
To put it bluntly, Glass-Steagall was counterproductive and wholly unnecessary. Yet, today, some people maintain that we shouldn’t have repealed Glass-Steagall; that letting banks buy stocks is just dumb.
Those people are wrong on two counts. The 1999 law that supposedly repealed Glass-Steagall didn’t. It repealed only two sets of four restrictions so that commercial banks could legally affiliate with investment banks. But even if it had repealed all four sets of restrictions, there would still be regulations that prevent banks from being able to just start buying stocks willy-nilly.
Despite fervent and widespread belief that Glass-Steagall was a roaring success, Congress was able to uncover precious little evidence that it was fixing anything. Indeed, there is virtually no evidence that banks engaging in securities activities prior to Glass-Steagall were in worse financial condition than their specialized peers.
In fact, evidence actually shows that banks engaged in both types of financial activities – commercial banking and investment banking – were stronger than those institutions engaged in only commercial banking.
From 1930 to 1933, 26.3 percent of all national banks failed, but only 6.5 percent of the 62 banks with securities affiliates as of 1929 failed. Similarly, only 7.6 percent of the 145 banks with large bond operations failed.
The record also shows that the 1933 Glass-Steagall restrictions protected Wall Street investment banks from their commercial bank competition (and vice versa).
So it was disappointing when, during his campaign, President Trump called for a “21st century Glass-Steagall.” Of course, the details were murky, and there could be a huge difference between a 21st century version of Glass-Steagall and the original version.
After the election, many observers assumed Gary Cohn, Trump’s National Economic Council Director, would be an internal force against a return to Glass-Steagall.
But just last week, Cohn reportedly told several Senate Banking Committee members that he would support a Glass-Steagall-type separation between commercial banking and investment banking firms.
In all fairness, it is still unclear exactly what the administration will support. The folks at Treasury are undertaking a thorough review of financial market regulation as per an Executive Order signed in February.
So there’s still a great deal of time to discuss these issues and figure out how to implement the best financial market regulations possible. In the spirit of furthering that discussion, here are a few Glass-Steagall facts that policymakers should keep in mind.
- The earliest and most noteworthy financial disasters during the 2008 crisis were pure investment banks (Lehman, Bear Stearns, Merrill Lynch) and pure commercial banks (Washington Mutual, Wachovia).
- Glass-Steagall-type restrictions would not prevent banks from taking “risky bets” with insured deposits unless the restrictions prevent banks from making consumer and commercial loans.
- The 1933 Glass–Steagall separation applied only to U.S. banks’ domestic Internationally, U.S. commercial banks regularly offered securities services. By the 1980s, the top 30 Eurobond underwriters were U.S. bank affiliates. Citicorp offered investment-banking services in over 35 countries, and Chase Manhattan had offices in almost twice as many countries as 10 major investment banks combined.
- Ferdinand Pecora, chief counsel for the Senate Committee on Banking and Currency, conducted politically successful hearings in 1933 and 1934 that won him the nickname The Hellhound of Wall Street. Virtually none of the more than 11,000 pages of testimony from these hearings provides evidence regarding the safety and soundness of commercial banks and their securities affiliates.
Much like the frenzied environment on Capitol Hill during the 2008 financial crisis and the passage of the 2010 Dodd–Frank Act, most of the Glass–Steagall-related hearings were more focused on casting blame than shedding light on – and actually fixing – the problems that caused the crash.
In both instances we ended up with legislation that tried to design financial markets by dictating precisely who can take which financial risks. This approach does not make markets safer.
Instead, it harms consumers via higher prices, fewer choices, and less opportunity because it protects firms from competition. And it ends up being consumer protection for billionaires.
Even Sen. Elizabeth Warren (D-Mass.), the consummate Wall Street critic who sponsored a new Glass-Steagall bill to separate commercial and investment banking, has admitted that those restrictions would not have prevented the 2008 crisis (or even the well-publicized JP Morgan “London whale” trading loss).
Re-implementing Glass-Steagall-type restrictions is a simple-sounding reform that actually does nothing to fix the real problems in the financial system. Many of these problems center on the horrible incentives that federal policies create, and they’re going to be very difficult to deal with.
Here’s just a few:
- Federally backed deposit insurance creates terrible incentives in the banking industry, and the problem has steadily worsened since the 1930s. FDIC insurance now goes well beyond protecting the average depositor.
- In 2005, swaps, repos, and mortgage-related securities received special exemptions from bankruptcy provisions, making counterparties less interested in how safe the instruments were.
- The mortgage-backed securities (MBS) at the heart of the 2008 crisis were explicitly blessed as safe by federal regulators, with the express goal of funding more nontraditional mortgages.
These issues have well-connected constituents that will fight to the death to keep their advantages. But if we’re going to improve the incentive structure in financial markets and make things safer and more efficient, policymakers have to address these issues.
The U.S. has a terrible track record in this area, and Glass-Steagall is just one example of the many bad polices Congress has implemented.
Perhaps the 21st century is the time to get it right.
*Originally published in Forbes, click here.