A popular idea that has taken root in people’s imaginations is that “Glass-Steagall” would have “saved” the United States from the vagaries of the financial crisis.
My objective here is to argue that it would have done no such thing. Now, I fully understand that it is extremely difficult to argue a counterfactual (what would have happened if…), however, I still think this is a post worth making.
I should state clearly that I am not arguing against financial regulation in general, or even against stricter regulation. I still believe that excessive leverage was a large contributor to the crisis, I believe that the incentives in the mortgage markets were bad and I believe that derivatives should have been regulated earlier among other things.
However, I do not think that Glass-Steagall would have made a difference in the crisis that ensued. I make this post in the hopes that we can finally move beyond this trope and have a reasonable discussion about financial regulation on this website and elsewhere in the public sphere.
What is the Banking Act of 1933 or “Glass-Steagall?”
The Glass-Steagall Act, also known as the Banking Act of 1933 (48 Stat. 162), was passed by Congress in 1933 and prohibits commercial banks from engaging in the investment business.
Basically, commercial banks, which took in deposits and made loans, were no longer allowed to underwrite or deal in securities, while investment banks, which underwrote and dealt in securities, were no longer allowed to have close connections to commercial banks, such as overlapping directorships or common ownership.
I should note that the Glass-Steagall act also created the FOMC and the FDIC, though the FOMC was not given voting rights till 1942. In addition, Glass-Steagall also established Regulation Q, a series of interest rate controls, which were abolished in the 1980s.
Needless to say, this post is about the separation of banking activities, not the formation of the FOMC or the FDIC or any of the other provisions of the Banking Act of 1933.
Causes of the financial crisis
Let us also outline the causes of the crisis. I think Alan Blinder came up with the best, most concise list, so I will shamelessly steal from him:
- inflated asset prices, especially of houses (the housing bubble) but also of certain securities (the bond bubble);
- excessive leverage (heavy borrowing) throughout the financial system and the economy;
- lax financial regulation, both in terms of what the law left unregulated and how poorly the various regulators performed their duties;
- disgraceful banking practices in subprime and other mortgage lending;
- the crazy-quilt of unregulated securities and derivatives that were built on these bad mortgages;
- the abysmal performance of the statistical rating agencies, which helped the crazy-quilt get stitched together; and
- the perverse compensation systems in many financial institutions that created powerful incentives to go for broke.
At first glance, one might say, hold up, doesn’t point 3 say that Glass-Steagall should have been in place? My response to that is no, no it does not. See the next section.
A closer look at the financial institutions that failed
Bear Stearns: A pure investment bank which failed because it had too much leverage and lots of dodgy assets on its balance sheet. The Fed engineered a rescue via clever use of guarantees and it got absorbed into JP Morgan. The Fed made a small profit on the whole thing.
Merill Lynch: Absorbed into BoA. It too ventured too deeply into subprime mortgages. It’s CEO. Stanley O’Neill, wanted to become a “full-service provider.” This meant that he wanted Merill to both originate the mortgages andwrite the CDOs. To this extent, Merill acquired First Franklin, one of America’s biggest subprime lenders, in 2006.
Lehman Brothers: A very similar story to the other two, just more highly leveraged. It’s failure was so bad that every attempt to find a purchaser fell through. It failed despite the Fed’s best efforts to arrange a private deal. The Fed could have bailed it out (Bernanke argued it would have been illegal because the 13(3) emergency lending authority required good collateral) but, it did not. Others have argued that it was allowed to fail – A conclusion I agree with.
Goldman Sachs & JP Morgan became bank holding companies.
At the end of the bloodbath, there were no freestanding investment banks. The failures of the investment banks were not linked to Glass-Stegall. Merill, Lehman and Bear would have acquired those dodgy CDOs, etc on their balance sheets anyway. Nothing in Glass-Stegall prevented any of this from happening.
Washington Mutual: A little more than a week after Lehman, contagion spread to WaMu. By September 25, it had lost about 9% of its deposits and was suffering a bank-run. Normally, the FDIC closes a failing bank on Fridays hoping to resolve it over the weekend before it opens for business on Monday. However, on September 25, 2008, a Thursday, the FDIC decided it could wait no longer.
Wachovia: After WaMu, a “silent run” began on Wachovia. The run was silent because instead of depositors lining up to withdraw their monies, the withdrawals were mostly done by sophisticated financial entities (ie people sitting at their keyboards). It lost $5 billion of deposits on one day. On the weekend of September 27-28, the FDIC made it close up shop. There was a tango between Citigroup and Wells Fargo, which Wells Fargo won and bought out the carcass of Wachovia.
Other Financial institutions
AIG: The giant elephant in the room. Right after Lehman, AIG was in big trouble. AIG failed mostly because of AIG FP- an entity it had set up to make a ton of CDS bets. Bernanke described AIG FP in the following way:
AIG exploited a huge gap in the regulatory system. There was no oversight of the financial products division (this is AIG FP). This was a hedge fund, basically, that was attached to a large and stable insurance company, made huge numbers of irresponsible bets.” He added, “If there’s a single episode in this entire 18 months that has made me more angry, I can’t think of one, than AIG.”
Basically, AIG engaged in some clever “regulatory shopping” to have AIG FP classified as a “thrift” which was then supvervised by the hapless OTS (Office of Thrift Supervision).
I am going to skip over Fannie & Freddie, GMAC, other small subprime players such as Countrywide, IndyMac (which later became OneWest under your future Treasury secretary, Steve “Munchkin” Mnuchin). Nothing in GS would have saved these firms either.
Would GS have made a difference to any of this?
I return to the seven points put forth by Alan Blinder. GS would not have prevented excess leverage. GS would not have prevented the bubble in MBS/ABS markets or the creation of such innovations such as CDOs and CDO2 It would not have saved any of the big investment banks from getting into trouble nor would it have saved the commercial banks from making dodgy loans.
GS did not have anything to do with the practice of paying employees for the volume of loans they generated rather than the quality (because originators could package them up and sell them up the food chain).
GS did not have anything to do with the shadow banking industry or the off-balance sheet vehicles (SIVs) or the bad incentives at large ratings firms (they are paid by their clients to grade securities their clients produce).
Should all of these problems be fixed? Yes, and Dodd-Frank went some way towards correcting all this (a topic for another post).
However, blind calls for Glass-Stegall often miss the point that it wouldn’t have done anything to prevent the crisis.
The travails of Bank of America, Wachovia, Washington Mutual, and even Citi did not come—or did not mostly come—from investment banking activities. Rather, they came from the dangerous mix of high leverage with disgraceful lending practices, precisely what has been getting banks into trouble for centuries.
A note on the situation today
“Too big to fail” remains a popular theme and is often mixed up with Glass-Steagall, but has nothing to do with it. The implicit “TBTF subsidy” has greatly declined since the crisis. Dodd-Frank has done a lot of good and the United States should continue to build on it. Higher capital and liquidity requirements, living wills, centralised derivatives clearing and other measures have gone some way towards addressing the causes of the crisis.
Important parts such as ratings agencies were left largely untouched. A pleathora of regulations remain to be written.
The debate we (and by we, I don’t mean people on this subreddit, I mean people in general) should be having regarding financial regulation should be sensible and focused on whether “big banks are worth having,” systemic risk, sensible capital requirements and sensible protection for consumers.
There is good recent research that finds increasing returns to scale in the banking industry. and there are arguments to be made that “economies of scale are a distraction” and clean resolutions is what policy makers should focus upon.
Let us have those debates instead of throwing around the term “Glass-Steagall.” Let us move the conversation forward.