Would resuscitating a Depression-era banking law strengthen the financial system that we have today? There are many, including me, who believe a reinstatement of Glass-Steagall would help separate the risks of high-velocity, high-volume securities speculation from the pedestrian activity of holding retail deposits. Often forgotten in the discussion of Glass-Steagall is the law’s primary accomplishment: the creation of deposit insurance through the FDIC, which promptly ended the recurring curse of mass withdrawal of retail deposits during financial crises. My grandparents lost all their savings in the banking crisis of 1933. In the wake of Glass-Steagall, the idea that their bank deposits were insured must have seemed like a miracle to them. This act established confidence in the banking system among everyday savers.
Yesterday, DealBook’s Andrew Ross Sorkin took up the issue of Glass-Steagall in a piece focusing on Massachusetts Senate candidate Elizabeth Warren. Sorkin argues that the dismantling of Glass-Steagall was not the cause of the financial crisis. Furthermore, he says that Warren’s proposal to reinstate Glass-Steagall is misguided and would not have prevented the global meltdown of 2008.
I don’t want to speak for Warren, a Harvard Law School professor, but I think what she is pointing to is the need for an updated version of the law, a Glass-Steagall 2.0. Sorkin’s description of why Glass-Steagall would have done little to avert the financial crisis of 2008 parrots the argument made by Wall Street’s elite. See this Bloomberg piece from December 2009, for instance:
“If you look at what happened, with or without Glass- Steagall, it would have made no difference,” said H. Rodgin Cohen, chairman of New York-based law firm Sullivan & Cromwell LLP, who represented one side or the other in more than a dozen transactions stemming from the financial crisis last year, including the rescues of Bear Stearns Cos., Fannie Mae, Wachovia Corp., and American International Group Inc.
Cohen and others say the law wouldn’t have saved Bear Stearns or Lehman Brothers Holdings Inc., both of which were pure investment banks, from collapse. And the government would not have been able to enlist JPMorgan Chase & Co. to take on the assets of Bear Stearns or allow Goldman Sachs Group Inc. and Morgan Stanley to become bank holding companies, giving them access to the Federal Reserve’s discount window.
Sorkin and Cohen are attacking a straw man. Few are advocating a reinstatement of the statute as it existed on the books in 1933. Banks are different beasts now; the largest of them are massive depository institutions with securities trading and investment banking operations bolted on the side. It’s the massive leverage and the speculation of the trading and investment banking arms that concern so many. Adair Turner, the former chairman of the UK’s Financial Services Authority, said in a 2009 speech to the British Bankers Association:
The key point to recognize is that the activities which caused the crisis were not ones which had been previously defined, under for instance Glass Steagall, as clearly outside commercial banking – activities such as equity underwriting and distribution – but activities which seemed close to the core functions of commercial banks such as credit intermediation, liquidity provision and interest rate risk management. Much of what went wrong went wrong in activities which a commercial bank was free to perform even before Glass Steagall was dismantled.
It is, I think, difficult to imagine applying a law which says that a commercial bank cannot hold fixed income securities in its Treasury portfolio, turn loans into securities for distribution but hold them until distribution is achieved, or use credit derivatives to manage credit risks. And you certainly cannot say that a commercial bank cannot take any proprietary positions, without making it impossible to perform necessary market-making functions in, for instance, foreign exchange and interest rate markets.
But once you have said that a commercial bank can do all of those functions, you have allowed it to do most of the activities which, pursued on a large scale and in a risky fashion, caused the crisis.
Let’s not fight the last war. It’s the spirit of the old law that Warren and others are advocating. Glass-Steagall 2.0 proponents like me would like to see a return to a sound banking system where speculative activities are isolated from insured deposits. Many have said that Dodd-Frank has given regulators the tools to dismantle a failing megabank, but no one believes that will avert the next financial crisis.
Our most important goal is to rebuild confidence in the financial system. To accomplish this, a new version of Glass-Steagall is needed, one that ring-fences retail savings from the risk of catastrophic loss from speculative activities.