December 2009
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Bring Back Glass-Steagall
If we've learned anything from the economic downturn of the past two years, it's that no corporation is too big to fail—not the domestic automobile industry and certainly not the U.S. banking industry. We've seen firsthand how the vicious cycle works, from banks and lending institutions making risky subprime mortgage loans, to eventual foreclosures, job losses, falling incomes, declining spending, and business failures.
More than 120 banks have failed in the past two years, according to the FDIC, in large part due to the risky investments they have been making, such as mortgage-backed securities.
There is a potential solution, however: Bring back the Glass-Steagall Act.
For the better part of this decade, I have advocated for the return of Glass-Steagall. The idea has recently gained nationwide interest in the wake of the overwhelming number of bank failures and thanks to the vocal support of Paul Volcker, chairman of the Federal Reserve from 1979 to 1987, and Nobel Laureate and Columbia University Professor of Economics Joseph E. Stiglitz.
Just as there is separation of church and state, there should be separation between commercial banking and investment banking—the original purpose of the Glass-Steagall Act of 1933.
Frankly, just as there is separation of church and state, there should be separation between commercial banking and investment banking—the original purpose of the Glass-Steagall Act of 1933.
Glass-Steagall came about as a result of the 1929 stock market crash. The idea seemed simple enough—keep commercial banks out of the investment business. This common-sense separation worked for 66 years, until the Gramm-Leach-Bliley Act of 1999, signed into law by then-President Bill Clinton, effectively repealed Glass-Steagall. It allowed banks to own other financial institutions and engage in investment practices such as stock market investing, bond trading, collateralized debt obligations, subprime lending, currency trading, and more.
Risky Business
Commercial banks began the practice of trading risky securities, but nobody seemed to understand exactly how to define “risky.” Banks were able to take on risk because they were playing with house money—your money, in the form of your deposits in their institutions. If an investment gamble doesn't pan out, they don't have to cover the loss; your deposits are protected (now up to $250,000) by the federal government. If they win big, they get to keep all the winnings—realizing profits that were made off your monies. Except you don't get to see those profits. You share some of the risk and none of the reward.
Volcker is a very learned man, and his call for the reenactment of Glass-Steagall should be heeded. He was quoted in the New York Times on October 21, 2009, as saying, “The banks are there to serve the public, and that is what they should concentrate on. These other activities create conflicts of interest. They create risks, and if you try to control the risks with supervision, that just creates friction and difficulties.”
Volcker, in his current role as head of the President's Economic Recovery Advisory Board, is in a position to offer good advice to the administration. So far, the biggest argument against the return of Glass-Steagall is that securitization will still exist because commercial banks would still be able to sell their mortgages to investment banks, which would then do the securitization.
That's partially true, yes, but the overall benefits of separating the two far outweigh the risk. Even some bankers know that. Ron Hermance, Hudson City Bancorp's chairman and CEO, was asked recently if he agreed with Volcker's desire to reenact Glass-Steagall: “I absolutely agree with him. Glass-Steagall's [repeal] was the beginning of the end. In other words, too many powers for too many people. Not as easy to understand for analysts or regulators, for that matter.” He suggested, “Separate it out. Make it an investment bank; make it a [commercial] bank. That's the smartest way to go at it.”
There's an old saying: If it ain't broke, don't fix it. In 1999, the original intent of Glass-Steagall had been compromised far too many times by banks looking to become bigger by offering more services. But repeal wasn't the answer. And now we need to fix our banking sector. Again.
Reenact Glass-Steagall.