Monday, December 5, 2016

Why Another Glass-Steagall Would Be Ineffective Banking Reform

Deregulation. It's that word that many on the Left are fond of using to scare you in thinking that a world without heavy-handed government intervention would be a scary, unguided one. This is especially true when we're talking about something like the financial sector, or more specifically with banking. During the presidential election, Democratic candidate Bernie Sanders called for breaking up the big banks, which would not have been a smart move. Democratic Senator Elizabeth Warren tried passing a 21st-century version of Glass-Steagall, which was a bill passed back in 1933 that required commercial banking and the investment market (i.e., securities trading) to be separate. What is more peculiar is that Trump has called for a bill similar to that of Senator Warren. What is it about Glass-Steagall that causes such controversy? What sort of role has it played in shaping the banking sector, and do we need legislation similar to that of Glass-Steagall?

The Glass-Steagall Act, also referred to as the Banking Act of 1933, was a Depression-era bill that prohibited commercial bankers from engaging in investment banking. The primary idea behind the bill was to make sure that commercial bankers were not exacerbating the financial situation by gambling with depositors' funds in the stock market. This seventy-plus-year old piece of legislation still plays a role in the public policy realm because the narrative that is common on the progressive Left is "watering down Glass-Steagall and deregulation of the financial sector caused the Great Recession, and only further regulations, such as an updated Glass-Steagall, will save us." While this wonderful, recently-released paper from Cato Institute scholar Oonagh McDonald covers the more historical aspects of Glass-Steagall, as well as these reports from Congressional Research Service and Heritage Foundation, let's briefly take a look at the history to see why I take issue with this narrative.

  • A Rugters University study (White, 1986) found that banks from 1930 to 1933 (a time period where banks were massively failing during the Great Depression) that dealt both with commercial and investment banking were more than twice as less likely to fail, not to mention that none of the 5,000 bank failures in the 1920s involved securities dealings affiliates. In short, there was no evidence that banks with securities affiliates, which is what Glass-Steaggal was targeting, were more susceptible to failure. 
  • The Clinton Administration signed off on the Gramm-Leach-Biley Act (GLBA) in 1999. The GLBA was a partial repeal of Glass-Steagall, specifically that of Sections 20 and 32 of the Glass-Steagall Act. Section 20 stated that a bank could not have a majority or controlling share in a securities firm. Section 32 prohibited banks from having interlocking directorships primarily engaged in the underwriting, dealing in, or distribution of securities. What the GLBA allowed for was affiliations between commercial banks and firms involved in securities underwriting, as well as interlocking management (McDonald, 2016, p. 12).
  • The GLBA did not cover Sections 16 and 21. Section 16 limits commercial banks to purchasing and selling securities for customers, as well as prohibiting them from dealing in or underwriting securities on their own accounts. Section 21 prevents securities firms from taking deposits. Both of these Sections are still in effect to this day. What this means is that while commercial banks can be affiliated with investment banks, they are still considered two separate institutions. 
  • The interesting part is the effects of the GLBA, which were negligible. Politifact determined that altering Glass-Steagall in 1999 did not cause the Great Recession, at least in part because it was so whittled down, but mostly because there is not an economist out there arguing that Glass-Steagall was the sole lynchpin holding together the financial market. Even NPR said that, at best, Glass-Steagall was one of many other underlying causes. 
  • Even when Glass-Steagall was gradually being eroded over the past few decades, American banks in Europe operated the same way as the banks in the local jurisdictions, and guess what? There were not any severe or adverse consequences as a result of not having Glass-Steagall (McDonald, p. 9). 
  • Given the institutions that started the domino effect of the Great Recession, it's difficult to see how Glass-Steagall would have prevented it. Bears Sterns, Lehman Brothers, and Goldman Sachs were stand-alone investment banks that did not take deposits. Fannie Mae and Freddie Mac were not even banks. Wachovia and Washington Mutual got into trouble during the Great Recession because of their mortgage portfolios. Another way of saying this: Glass-Steagall would have done nothing to prevent the Great Recession.
  • Between 1997 and 2008, the number of financial regulatory restrictions actually grew from 40,286 to 47,494 regulations. From 2000 to 2008, the Federal Register added 7,100 pages of financial regulations. Looking at the regulatory measures leading up to the Great Recession show that deregulation did not cause the Great Recession.
  • Even better, one of the most basic rules you learn in Finance 101 is that diversification reduces risk. The banks that were in the most trouble in 2008 were the ones that lacked portfolio diversification. This lack of diversification was also a major issue with the small unit banks during the Great Depression (McDonald, p. 8).
  • Two things that Glass-Steagall was never designed to do: regulate the size of banks and prevent banks from buying and selling securities for their own investment purposes. 

Understanding the history of public policy, especially with something as complicated as Glass-Steagall is important because it helps us understand policy today. We can focus on a more noble goal of helping prevent losses to the depositors, but at the same time, prohibiting affiliations between commercial banks and investment banks does not help with that noble goal. We already have evidence that Glass-Steagall did not help with the Great Depression, or that a partial repeal of Glass-Steagall caused the Great Recession. While you can argue that "just because it didn't help in the past, it can help in the future," the burden is on the advocate for Glass-Steagall, especially in light of its past inefficiencies. After all, it's not just libertarian or conservative think-tanks that think Glass-Steagall was and is bad policy. It is also coming from the centrist Brookings Institution.

If we are to forget for a second that Glass-Steagall has not worked, what would a revival of Glass-Stegall look like? A major part of what resulted in the whittling down of Glass-Steagall was technological. By the 1970s and 1980s, technological development allowed for greater access to financial data, which made it cheaper and easier for businesses to decide what financial investments to make. Also, the line between commercial and investment banking has been since blurred, making Glass-Steagall all the more irrelevant. By the mid-1980s, securities firms were getting a huge advantage, and if it were not for the GLBA, commercial banks would have been forced out of financing for all but the smallest of businesses. If we revive Glass-Stegall, it would make it more difficult to support subsidiary banks, which would make bank failures and taxpayer bailouts more likely in the future. There is no sense in weakening banking institutions further. Even the centrist Brookings Institution concludes the following:

"Combined groups benefit from the diversification effect of having both businesses together. Usually, one side does better than the other in troubled times, reducing the risk of failure. Since the Crisis demonstrated that investment banking failures can be nearly as devastating to the economy as commercial banking failures, there is clear value in diversification to protect both sides. This is a major reason the big failures were in firms with purer focuses."

Let's talk about whether Trump's idea to dismantle Dodd-Frank is a good idea. Let's talk about how we can prevent the government from propping up another housing bubble, we can create sound monetary policy to mitigate financial pressures, or why breaking up big banks is a bad idea (see here and here). But let's stay away from an antiquated, irrelevant piece of legislation that did nothing to help with past financial crises and does not show any promise of helping prevent future ones.

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