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We need a stronger Glass-Steagall Act to regulate financial firms

The 1933 law, which in effect barred commercial banks from owning investment banks, was repealed in 1999. A former Treasury Department official proposes an updated version.

May 30, 2012|Michael Hiltzik
  • Glass-Steagall was repealed in large part because of the lobbying efforts of Citigroup.
Glass-Steagall was repealed in large part because of the lobbying efforts… (Reuters )

"Bring back Glass-Steagall!" That's the cry you hear most often for restoring regulatory stringency to our misbehaving financial sector.

The 1933 law, which barred commercial banks from underwriting or investing in stocks — in effect, from owning investment banks — was repealed in 1999, and reinstating it is a good proposal for several reasons. But what the 2008 financial crash and misadventures such as JPMorgan Chase's multibillion-dollar derivatives loss tell us is that reinstatement of the old law isn't enough. What we really need is a sort of 21st-century Glass-Steagall Act with a laser focus on the activities that threaten the financial system in the modern era.

The biggest threat comes from financial firms' increased reliance on unregulated short-term borrowing, including fancy derivatives and money-market instruments that are vulnerable to panicky runs. In the old days, when Glass-Steagall was enacted, the only major form of short-term borrowing was bank deposits. That's why they were specifically protected via the Federal Deposit Insurance Corp., another New Deal measure, which all but eliminated bank runs after its creation in 1933.

But the 1990s brought an explosion of new forms of short-term capital to the banking industry. This capital looked like deposits, in that it was cheap to acquire and subject to instant demands for redemption; investment banks and securities dealers got hooked on it because other forms of capital, such as equity, were more expensive. But the new funding sources aren't insured like deposits, and their issuers haven't been supervised the way the FDIC keeps its eye on deposit-taking banks.

The result, says Morgan Ricks, was the crash of 2008. Ricks, a former Treasury Department official now at Harvard Law School, proposes to update Glass-Steagall, in effect, by redefining banks as any institutions reliant on short-term capital and significantly tightening their regulation. In the recent past, those institutions included Bear Stearns and Lehman Bros., non-banks whose failures arguably launched the financial crisis.

"We think of the ultimate cause of the crash as [banks'] losses on mortgage assets," Ricks told me recently. "But losses happen, and they're not a big deal unless we have this unraveling in short-term markets. That's what sends the economy into free-fall."

The Glass-Steagall approach, he observes, doesn't get at the core problem — Lehman Bros. was a pure securities firm, unaffiliated with a depository bank. "Yet its failure nearly brought down the whole financial system and the economy." It may also be true that Glass-Steagall would not have prevented JPMorgan's derivatives trading, which was conducted entirely on the commercial-bank side of the company — though it may yet turn out that the transactions crossed the line into investments forbidden to commercial banks under the old law.

Ricks proposes dividing financial firms into two categories. Those such as banks that want to live on deposits, "repos" and money-market funding would require a government license and be subject to stringent regulation of their safety and soundness. They'd be guaranteed a government bailout if things went wrong, but they'd also have to pay a stiff fee in advance for that guarantee.

Unlicensed firms wouldn't be permitted to fund themselves in the short-term market — their capital would have to come entirely from the equity and bond markets. Nor would they be eligible for a government bailout. "We'd just let you go bankrupt if you fail," Ricks says.

Indeed, there are plenty of examples of financial firms that failed without threatening the economy, because they had no short-term credit entanglements to spread the contagion. The commercial lender CIT Group, for instance, went bankrupt in 2009 with some $70 billion in liabilities — but because its capital came entirely from equity and debt, its failure caused scarcely a ripple in the financial markets and it promptly reemerged as a going concern.

Ricks' proposal would have several positive effects. Securities firms forced to fund themselves in the long-term markets would be smaller albeit less profitable than today's behemoths, solving the "too big to fail" problem at a stroke. Money market funds would probably fade away, because the new rules would make their business models untenable. They'd be unlamented by regulators such as Securities and Exchange Commission Chair Mary Schapiro, who said in February that these funds are so susceptible to panic-driven runs and so poorly supervised that we are "living on borrowed time" before a blowup in the sector threatens the stability of the financial markets.

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