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Explainer: Is Glass-Steagall Back? And Would it Prevent the Next Financial Crisis?

Wednesday, November 30, 2011

Federal Reserve Board Chairman Ben Bernanke walks away from the podiuim after delivering remarks September 15, 2011 in Washington, DC. (Chip Somodevilla/Getty)

Bloomberg News reports what the Federal Reserve wouldn't: that the United States' central bank committed $7.77 trillion to bailing out the financial industry in the wake of the 2008 crisis, netting banks $13 billion in profits in the process.

The Fed's bailout package was more than ten times the $700 billion that the Treasury Department spent on its oft-maligned (and much more public) Troubled Asset Relief Program.

The issue

The details of these "secret Fed loans" were kept out of the public eye for years, and come to light now only after a Freedom of Information Act request and a lengthy court battle. According to the Bloomberg article, elected officials were "kept in the dark." Not even Massachusetts Senator Barney Frank, whose name is on the most recent piece of financial reform legislation, was aware of the specifics of the Fed's "emergency efforts."

All of which has prompted the rather roundabout reconsideration of an almost-80-year-old law—or rather, whether or not scrapping it in 1999 was a bad idea. That law is the Glass-Steagall Act, and it's increasingly common to hear about it in any discussion of financial regulation. Tastes have gone vintage; reinstating the law is in vogue.

Resurrecting Glass-Steagall isn't just a popular idea among policy wonks, pundits, and web commenters; it's gaining traction with an unlikely array of politicians, too. Bloomberg reports that former Democratic Senator Byron Dorgan specifically said that knowledge of the Fed's loans "might have helped pass legislation to reinstate the Glass-Steagall Act." Less than a month ago, Republican presidential candidate and the GOP's "intellectual leader" Newt Gingrich went on record with ABC's Jake Tapper saying that repealing Glass-Steagall over a decade ago was "probably a mistake." Republican Rep. Paul Ryan, who chairs the House Budget Committee, backed him up.

Just what was Glass-Steagall, and what separates it from the recently-passed Dodd-Frank? Most importantly, would it really protect us from a repeat of the 2008 disaster?

What it did (and where it went)

The Glass-Steagall Act, officially known as the Banking Act of 1933, was a Depression-era reform that separated commercial banking from investment banking: an institution could either take deposits or trade securities, but it couldn't do both.

In essence, deposits were shielded from losses that might come of more risky activities involving securities. Glass-Steagall also created the Federal Deposit Insurance Corporation, which insured those deposits. Protecting them from risk attributed to securities made sense: if the government was on the hook to insure those deposits, it didn't want depository institutions risking securities losses.

Legislators under the influence of lobbyists would chip away at Glass-Steagall beginning the 1970s, as looser restrictions on banks were seen as a way to counteract the dangerous impacts of inflation. It wasn't until 1999, when Congress passed the Gramm-Leach-Bliley Act, that the central provision of Glass-Steagall was abandoned; a holding company was finally allowed to control both commercial and investment banks.

What it would change...

In short, repeal of Glass-Steagall allowed commercial lenders to make loans (say, in the form of mortgages) and trade instruments derived from those loans (say, in the form of mortgage-backed securities). Commercial banks could even create new investment entities that would be responsible for buying those securities.

The expanded palette of products and operations that were available in the wake of Glass-Steagall's repeal certainly contributed to the financial crisis, as banks took risks with their customers' deposits and debts that were previously illegal. Banks had new ways to make money, and new license to get "too big to fail"; a holding company could hold and create whatever it wanted.

Reintroducing Glass-Steagall would change that.

...and what Dodd-Frank didn't

For all the regulations and oversight afforded by the Dodd-Frank Act of 2010, it doesn't separate investment banking from commercial banking. Those senators saying they might have approached post-crisis financial regulatory reform differently if they'd known about the Fed bailouts: this is partially what they mean.

Dodd-Frank essentially imposes two other restrictions on large financial institutions: it allows the government to liquidate certain failing financial institutions, and it imposes higher capital requirements "that make it undesirable to get too big." However, neither of these measures translates to separating banking functions or capping the size of a bank.

Higher capital requirements may make it "undesirable to get too big," but certainly not impossible. And the government's ability to liquidate an institution is severely limited: it's only a last resort, and subject to legal appeals in the event that the institution doesn't agree with the government's assessment.

Simon Johnson, former chief economist with the IMF and co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, says that the "resolution authority" granted by Dodd-Frank is an illusion. "The F.D.I.C. can close small and medium-size banks in an orderly manner, protecting depositors while imposing losses on shareholders and even senior creditors," Johnson writes in the New York Times "Economix" blog. "But to imagine that it can do the same for a very big bank strains credulity."

What it wouldn't change

It's that strain on credulity inherent in Dodd-Frank that has brought Glass-Steagall back into the national consciousness. Dodd-Frank seems only to take action after the fact: more government agencies overseeing a largely-unchanged financial industry; the possibility of liquidation, albeit unlikely, only once a firm presents a clear and present danger to the economy. People are beginning to view the separations enacted by Glass-Steagall, on the other hand, as pre-emptive measures against "too big to fail."

Many people who would cheer the return of Glass-Steagall also caution that it is not a magic pill. Glass-Steagall alone could not prevent the next financial crisis, say Simon Johnson and his co-author, James Kwak, in 13 Bankers. In addition to separating commercial and investment banking activities, they argue, there should be a well-defined limit on how large any financial institution is allowed to get; if they're above the limit at the time it's set, then they should be broken up and forced to reconstitute as a smaller entity.

As a starting point, Kwak and Johnson recommend that the government consider limiting a bank's holdings to no more than 4 percent of GDP. Currently, the six largest banks collectively hold assets equal to 66 percent of GDP.

A false sense of security?

But while steam is building behind a return to Glass-Steagall, the same cannot be said for legislation that would explicitly limit bank size. The Bloomberg report mentions 2010 legislation sponsored by Democratic Senators Sherrod Brown and Ted Kaufman to limit bank size that was ultimately unsuccessful. Paul Ryan and Newt Gingrich may be on board with dividing up financial institutions, but they've yet to come out in support of an outright limit on the size of any single institution.

The only Republican presidential candidate to bring bank size to the debate table has been Jon Huntsman, who at this point appears to have little chance in the primaries.

Bloomberg's story brings back into focus the shortcomings of current financial regulation, and highlights the steadily rising clamor for a return to Glass-Steagall on both sides of the aisle. For at least a few politicians and policy experts, however, re-enacting decades-old legislation won't be enough. Glass-Steagall would be a step in the right direction, but ultimately provide a false sense of security if we don't define "too big to exist."

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Comments [2]

Shep1986 from New Jersey

I want to agree with this. However I found a compelling argument from the other side that says repealing Glass-Stegall was irrelevant. I think the gist of his argument is that Canada's banking system did just fine and they never even had a Glass-Stegall Act. I think there are flaws in that theory, but I'm not sure what they are.

Here is the counter-argument that is making me be on the fence on this issue:
http://www.tomwoods.com/blog/repeal-of-glass-steagall-had-nothing-to-do-with-the-crisis/

what do you think?

Dec. 23 2011 03:34 PM

Nicely said.

It presents a viewpoint held by one of two groups of people.

The other group?

Why, those who accept 'campaign contributions' from banks and their lobbyists, of course.

Nov. 30 2011 10:09 AM

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