The Independent Market Observer

7/12/13 – It’s Back! Glass-Steagall Returns

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jul 12, 2013 9:50:58 AM

and tagged Debt Crisis

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For those of you who don’t know, Glass-Steagall was the law that, to put it at its simplest, separated deposit-taking banks from the investment banks. It was passed during the Great Depression to prevent Wall Street risks from affecting the normal day-to-day business of Main Street, which had happened prior to the Depression. It did this by prohibiting banks that offered deposit insurance from engaging in Wall Street activities like trading. The big thing is, it worked. There were no systemic banking crises like that of 2008 while the law was in force, from 1933 to 1999.

A modernized version was just introduced in Congress by Elizabeth Warren and John McCain, an interesting pair. Warren is the Massachusetts senator who made her name trying to regulate the financial industry, while McCain is a former Republican presidential nominee. They propose a very similar set of restrictions, with the express purpose of taking the financial industry back to 1998, before Glass-Steagall was repealed.

There are, of course, arguments against this. A common one is that Glass-Steagall would not have prevented the collapse of Lehman Brothers, which kicked off the financial crisis. While that is probably true, it doesn’t address the systemic risks created by the intertwined relationships between the commercial banks and Lehman, which served to extend the crisis into the real economy. The real question isn’t whether Glass-Steagall would have prevented Lehman’s collapse, but whether it would have limited the damage—and it probably would have.

The other argument against a new Glass-Steagall is that it would cripple the ability of U.S. banks to compete around the world. The implicit assumption behind this argument is that large banks need to be able to use depositor capital—government-insured deposit capital—to compete. Frankly, if the banks need a government guarantee to compete out there, with taxpayers providing a subsidy, then I’m not sure they should be competing.

The most powerful argument, in my opinion, is that a revived Glass-Steagall law would simply be too blunt an instrument, that the side effects would overwhelm the positive effects. As we discussed yesterday, the same argument is being made about the higher capital requirements proposed for banks. The flaw in this rationale is that the industry has shown a repeated ability to get around detailed rules. Simple, principle-based rules are much harder to game.

As for the side effects, we have to acknowledge that, while Glass-Steagall was in effect, the U.S. economy grew strongly. Whatever the side effects were, they were not too onerous and actually led to better results than we’ve seen since the law was repealed.

I took some heat in the mid-2000s for saying I thought the repeal of Glass-Steagall was a mistake, an idea that has recently become more popular. I still think it was, and I think 2008 proved it. Reinstating Glass-Steagall would lower the risk to the financial system, at an acceptable—and, in fact, very low—societal cost. That said, I don’t think the new law will pass. There are simply too many institutional interests aligned against it.

The value of this bill is in pushing forward other constructive alternatives. While banks might not want to hold more capital, they would prefer that to reinstating Glass-Steagall. The mere existence of the bill, with bipartisan sponsorship, makes other reform measures significantly more likely to pass. Whatever is done, the financial system—and, by extension, all of us—will benefit.

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