Glass–Steagall is Old News. Really…

October 13, 2015 0 Comments

The election cycle is drawing near, so naturally, there will be no shortage of the talking heads beating the dead horse on this particular issue. Of course, Glass-Steagall was never an economic/financial issue in 2008, nor in 2012. Not because people are worried about this issue (the Roper Center Archive reports that only ONE poll question referenced Glass-Steagall since 1935). If anything, political candidates use this issue for their political advantages.

Senator Ben Sanders and Governor Martin O’Malley are somewhat vocal when it comes to Wall Street and big banks. Both of them long for the days where the SEC reinstated the Glass-Steagall Act of 1933 and divided large banks into many small banks. Both candidates have also taken the time to attack Hillary for being soft on Wall Street, who surprisingly have taken a less populist approach on this issue. Hillary’s defense of Wall Street: Glass-Steagall is Old News.

The problem with Hillary’s position: She Isn’t Wrong.

Yes, Clinton has been wrong on many things. I’ve demonstrated that in the past, but even a broken clock can be right at least two times a day. We’ve been beating this dead horse for a very long time, and it has not gotten us anywhere. Now, Sanders and O’Malley want to create phony issues into resurrecting useless laws that fail to prevent bailouts, the growth of large banks and market crisis.

Glass-Steagall: What Is It?

Most people know about the Great Depression and the economic turmoil that it had on the financial industry. Many financial regulations were born as a result of that financial crisis, one of which is the US Banking Act of 1933, also known as Glass-Steagall.

These new banking regulations prevented commercial banks from conducting the following:

  • dealing in non-governmental securities for customers
  • investing in non-investment grade securities for themselves
  • underwriting or distributing non-governmental securities
  • affiliating (or sharing employees) with companies involved in such activities

Commercial banks were not allowed to deal in anything involving stocks, bonds or financial instruments. Investment banks, on the other hand, were not authorized to accept deposits. This act virtually kept the relationship between commercial banking and investment banking separate.

In 1999, the Clinton administration enacted the Gramm–Leach–Bliley Act, which essentially repealed the two provisions separating the relationship between commercial and investment banking. If Clinton isn’t getting enough flak for referring Glass-Steagall as “old news,” she receives flak for being married to the President, who eliminated a vital piece of regulation that could have prevented the crisis. Or so the rhetoric goes…

Glass-Steagall Has Nothing To Do With The Financial Crisis

Nothing. Of course, Sanders and O’Malley would attribute Glass-Steagall as a major part of the financial crisis. Banks once kept separate from one another, were now able to merge and take risky bets with taxpayer money. The problem with this logic is that it does not make any sense, for those who pay attention.

For example, in 2007, you have the downfall of four of the largest banks in America: Goldman Sachs, Bear Sterns, Lehman Brothers and Merrill Lynch.They were all PURE investment banks that never accepted any deposits and never operated on the commercial side of banking. Of course, this problem wasn’t just limited to the big four investment banks.

What about AIG (American Insurance Group)? An insurance firm. Nothing to do with Glass-Steagall. New Century Financial? A real estate investment firm. No Glass-Steagall there, either. What about two of the largest banks at the time: Wachovia and Washington Mutual? Of course, they got into trouble the old-fashioned way: by making risky loans to homeowners. Bank of America got into trouble with the same problems, but not because it purchased an investment bank, Robertson Stephens, but because they purchased a mortgage lender, Countrywide Financial.

Of course, I’m not implying that banks operated risk-free. Did investment banks create a shadow banking market that runs without the regulatory framework of the SEC and the Federal Reserve Board of Governors, which may have encouraged risky investments in toxic assets? Sure (If you want to learn more about shadow banking, I touch briefly upon it on this post). Did banks, in general, make lousy investments said toxic securities? Sure. However, all of these problems were associated with banks that merged as they were with banks that remained separate. The fact of the matter is, Glass-Steagall would have prevented none of this.

Both commercial and investment banks got into trouble for one reason only: making long-term bets with short-term money.

Most of the commercial banks got into trouble because they held large portfolios of Mortgage-Backed Securities. Glass-Steagall never prevented commercial banks from investing in mortgage-backed securities. Most of the investment banks got into trouble because they held large portfolios of mortgage-backed securities funded by short-term commercial paper. Glass-Steagall never prevented investment banks from issuing commercial paper or investing in securities.

Glass-Steagall, then, is about as much of a red-herring as it is now.

Glass-Steagall Doesn’t Prevent Banks From Becoming ‘Too Big To Fail.’

I’ve already touched upon “Too Big To Fail,” why our banks are TBTF, and why TBTF is never going to go away. What I haven’t done was touch upon how Glass-Steagall can never eliminate TBTF because it’s fairly obvious.

The repeal of Glass-Steagall also (wrongly) is attributed to the growth of many of our financial institutions. Even if you believe TBTF is a problem/privilege our financial institutions currently enjoy, you must also remember that TBTF was also an issue in 1984 with the bailout of Continental Illinois (Seventh largest bank at the time). It was also a problem in 1997 when the Federal Reserve conducted the rescue of Long-Term Capital Management because the hedge-fund posed a “systemic risk.” These incidents also happened, and Glass-Steagall — still an active piece of regulation in our books — failed to prevent any of it.

You must also remember that banks have become larger ever since we’ve gotten into the habit of propping up more major banks at the expense of smaller banks:

What does this mean in terms of financial regulation in the future, as well as prospects for “resurrecting” the Glass-Steagall Act? It means that this issue is more complicated than our political leaders likes to profess. It also means that this matter is well above the pay grade of any of our elected officials, including Hillary Clinton. Granted, I gave her credit and suggested that she isn’t wrong on this issue, but that doesn’t necessarily mean that she understands it, either.

I pointed out the main attributes of the ‘Too Big To Fail’ issue before:

  • ‘Too Big To Fail’ has existed for a long time.
  • ‘Too Big To Fail’ can NEVER be eliminated.
  • ‘Too Big To Fail’ offers us many competitive advantages.
  • Banks pay nothing for the privilege of being ‘Too Big To Fail.’

Clearly, history shows us that a bank doesn’t need to have $1 trillion dollars in assets or deposits to be ‘Too Big To Fail.’ After all, a bank can have $1 Trillion dollars in assets and engage in $0 worth of investments. What determines the ‘riskiness’ of the bank is the borrowed and how many times it has borrowed (or lent to) other financial institutions. You need to consider their leverage, as well as their counter-party risk. You need to find their exposure in different types of markets (futures contracts, credit-default swaps, etc.).

The problem is, unless there is an exact formula to determine how much risk banks should be able to take (there isn’t), legislation such as Glass-Steagall only serve as political red-herring, as most things. The only problem is, for such a complex issue that very few people understand, it isn’t going away anytime soon.

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