Arnold Kling  

Glass-Steagall 2.0?

PRINT
Democracy, Dictatorship, and t... The Stimulus Debate, Revisited...

Bruce Judson writes,


this post is linked to a petition asking the Financial Crisis Inquiry Commission and the Treasury Secretary to explain in detail their reasons for recommending, or not, a system that relies on a highly concentrated, limited number of interlinked financial entities who are clearly "too big to fail," and who mix activities that are vital to the health of the nation with high risk activities that are frequently described as a casino.

Pointer from, of course, Mark Thoma.

I agree with Judson that the heart of the problem is large, complex financial institutions gambling with taxpayer money. I agree that what I describe as the strategy to "regulate the heck out of those institutions" is not a promising approach. My mantra is that we need to make failure a credible and viable option for any private firm. At some level, that requires unbundling critical systemic functions, like check processing, from risky betting functions, like taking interest-rate risk or credit risk. Whether that requires creating separate corporate entities or making a cleaner separation within firms is not clear. In any case, it is a misnomer to describe this risk separation as "Glass-Steagall 2.0" Glass-Steagall was mostly about avoiding concentration of power in financial institutions--it never succeeded in creating a neat separation of risk (nor was that the intention).


Comments and Sharing





COMMENTS (4 to date)
Bruce Judson writes:

Arnold:

Thanks for your very thoughtful comments on my piece. I just wanted to note, so that there's no misunderstanding, that I agree with you 100% that the most pressing concern is to make failure a viable option for any financial concern.

This issue is discussed in detail later in the article, where I conclude that without the risk of failure we can never have real accountability.
I think this conforms to your mantra.

Your note suggests to me that perhaps the "too big to fail" risk might have been in sharper focus in the wording of the petition. In general, the goal of the petition, and accompanying article was to help stimulate open debate about the total risk to the financial system in the plan now advocated by Secretary Geithner, and as you so correctly point out this problem arises when firms are deemed to big to fail.

Your comments about the original Glass-Steagall Act's goal of limiting the concentration of power in the financial system are also appropriate. As you may know, I have written, with growing concern, about the political power that is inevitably exercised by wealthy institutions to attempt to maintain or enhance their position, and distort the free operation of markets. See Ecnomist's View "Income Inequality Data: Surprising and Frightening" (http://bit.ly/dVhCS). If the issue of "too big to fail" is addressed by ensuring that failure is a real option, I suspect that the solution will inherently address this concern as well.

Sincerely,

Bruce Judson

Bill Woolsey writes:

We can tell stories about problems that would develop because commercial banks are combined with investment banks. We can tell stories where these problems involve subprime lending and mortgage backed securities. We can even tell stories where these problems balloon into a financial crisis.

However, these stories do not reflect what actually happened, and so, Glass-Steagall is irrelevant to the actual problems that occurred.

Most of the commercial banks are in trouble because they have purchased mortgage backed securities. Glass-Steagall didn't prohibit banks from investing in securities.
The investment banks are in trouble because they also hold large portfolios of mortgage backed securities funded by very short term commercial paper. Glass-Steagall didn't prohibit investment banks from issuing commercial paper or investing in securities.
We can imagine scenarios where the investment bank branch of a combined firm convinced the commercial bank branch to purchase risky securities that it had underwritten But most commercial banks don't have investment bank operations, and all bought mortgage backed securities too.

My view is that commercial banks purchased them because they were AAA rated, had decent yields, and the regulators required little capital. It wasn't because they all had investment banks divisions that needed to get rid of them.

Similarly, we can imagine a commercial bank dumping its lowest quality mortgages and "making" its investment bank operation securitize them, and then, when the house of cards collapsed, their investment bank division would be caught with them. While there are problems with this story (and the others,) it isn't what happened.

Mortgage banks sold bad loans to investment banks, both stand alone and investment banks combined with commercial banks. And the investment banks underwrote mortgage backed securities and held the securities for investment purposes.

Finally, we could imagine that the investment banks were underwriting mortgage backed securities, and as part of the business, they had yet unsold securities. When the collapse of that market occurred, there were stuck with them and lost money. Somehow, the commercial bank divisions were on the hook for the loss. Perhaps because the commercial bank division was lending to the investment bank division. And so, the risky investment bank operations dragged down the commercial bank.

Interesting story. Close to the story told about why Glass-Steagall was supposed to be a good idea in the 1930s. Not closely related to the real reason why it was passed (because politically important investment banks didn't want to face the competition of commercial banks horning in on their lucrative operations.)

And, most importantly, it has nothing to do with the current crisis. The investment banks weren't stuck with mortgage backed securities because they hadn't got rid of them yet. They were holding them because they were a good business. The investment banks were funding their operations with commercial bank loans, much less loans from "captive" commercial bank partners, but with short term commercial paper.

With very creative interpretation, one might argue that the investment banks were really operating commercial banks. They were indirectly funding mortgage loans and the short commercial paper was like deposits. They were no longer just funding a underwriting operation and using commercial paper for "working capital" and having securities pass through their hands as they underwrote them and sold them off to investors. No, they were issuing quasi-deposits and making quasi-loans. But... it would take very creative interpretation of Glass-Steagall to prohibit this as being illegal competition with commercial banks.

And the reality is that both investment banks and commercial banks are in trouble because they held large portfolios of mortgage backed securities, not because they were tied to one another. As far as I can see, if Glass-Steagall had existed, the same thing could have, and I believe, would have, occurred.

CWK writes:

Eliminating the FDIC would seem to be the simplest way to ensure that check-cashing and risk-taking are done by separate institutions.

Beezer writes:

One of the best ways to sell a new security, mortgage backed or otherwise, is to convince a top line commercial bank to buy in early.

Ever since investment banks were allowed to sell FDIC insured CDs beginning in the 1980s, the real as well as the philosophic barriers between investment banking and commercial banking began to erode.

One of the markets lost by commercial banks to investment banks, as well as others, was the commercial paper market. More erosion and more risk (remember Orange County and Merrill Lynch?)

Glass Steagall was simply one of the more recent changes reinforcing the desire to commingle investment bank and commercial bank activities. The SEC exemption on leverage for some investment banks was another.

Commercial banks coveted the high profit trading and other investment banking activities. Investment bankers coveted the immense private wealth housed at commercial banks, and particularly wanted to rid themselves of the need to sell their commercial bank bretheren on their investment ideas. It was a royal pain in the derrier, take my word for it.

Glass Steagall gone (along with other changes) and mission accomplished. The inevitable result, high risk and the socialization of losses.

Both types of bankers liked the idea for different reasons. But the goal was the same and Glass Steagall was in the way. That's why it was brought down.

Comments for this entry have been closed
Return to top