Glass Steagall Redux: The TBTF Silver Bullet?

I was speaking to a senior manager at one of the prime brokers recently and he mentioned a  conversation he had with a client. The client asked him what his firm was going to do when the Glass Steagall regulation was re-enacted.  The client spoke about it as if it were just a matter of time.

In the ongoing Too Big To Fail (TBTF) discussion and calls to break up the big banks the conversation often turns to the re-enactment of Glass Steagall.  It is viewed by some as the ultimate solution to TBTF. But is it? Let’s look at two questions to evaluate this claim:  How different would the crisis of 2008 have been had Glass Steagall still been in place? And what problems would it solve today?

First let’s revisit the history of Glass Steagall. The Banking Act of 1933 sponsored by democrats Henry Steagall and Carter Glass[1], in a response to the 1929 market crash and subsequent Great Depression, separated commercial and investment banking activities. In the 1960’s the courts upheld more liberal interpretations of the act that allowed banks more leeway in securities transactions. This erosion of the Glass Steagall statute continued with Citigroup pushing the envelope with its 1998 merger with Salomon Brothers. The act’s ultimate repeal occurred in 1999 with the Gramm-Leach-Billey Act.

How would 2008 have been different if Glass Steagall has still been in place?

Critics of the repeal feel it led to the 2008 crisis by allowing banks to gamble with depositors’ money. This argument doesn’t hold up against the facts. The troubled firms at the heart of the crisis were non-banks that were not affected by the repeal of Glass Steagall: Lehman, AIG, Fannie and Freddie. The only real bank that got into serious trouble was Citigroup.  Bank of America was weakened by its purchase of Countrywide, a mortgage operation, a transaction that would not have been prohibited by Glass Steagall. J.P. Morgan remained strong during the crisis despite its large investment banking business.

What problems would the restoration of Glass Steagall solve today?

The primary reason that politician and pundits give for restoring Glass Steagall is that it will protect depositors if a bank fails because of losses in the investment bank. First of all depositors are insured by the FDIC. And remember what was at the root of the last crisis: bad mortgage loans. This is the bread and butter of commercial banking.

Keep in mind that Glass Steagall wouldn’t affect foreign banks that compete inside the US. So the US banks would be at a competitive disadvantage. This was one of the arguments to loosen the restrictions of the original statute. Also it would only really affect J.P. Morgan, Citigroup, Bank of America and Wells Fargo. Morgan Stanley and Goldman Sachs don’t have commercial banking businesses. So all this would be done just to break up four banks? Finally, and most importantly, Dodd Frank and Basel III have had a real impact on the riskiness of the major global banks.  Specifically the Volker rule, if enforced, significantly mitigates the trading risk that downed the major investment banks in 2008.

Conclusion

It is not just size that creates systemic risk but also interconnectedness. Lehman proved this and it’s hard to see how the resurrection of Glass Steagall would address this issue.  Its re-enactment would create unnecessary costs to the banks and consumers and the benefits don’t justify those costs. Reinstating Glass Steagall may make a great sound bite for the politicians but they clearly have not thought this through in any level of detail. (But if you’re a politician that’s what you do – to paraphrase a popular commercial). And while politicians and regulators continue to focus on the TBTF banks the unregulated shadow banking industry continues to grow.  We’re always fighting the last war.

[1] The Christopher Dodd and Barney Frank of their days.

Leave a Reply

Your email address will not be published. Required fields are marked *