Glass-Steagall: Not The Cause But Maybe A Cure?

As the idea of bringing back some form of Glass-Steagall gains traction, the naysayers are coming out of the woods. How many are funded by the vested interests in the status quo is hard to say but expect more of them. Tonight here is one of the first forays from the NY Times.

The idea of forcibly separating utility banking from casino capitalism has superficial attractions. The utilities, which would be tightly regulated, would focus on taking deposits and lending money. The casinos, which would be lightly regulated, could place bets on a range of assets. Paul A. Volcker, head of President Obama’s Economic Recovery Advisory Board, advocated some separation Friday at a conference at New York University’s Stern School of Business.

But Glass-Steagall would not have stopped the current crisis. For starters, many institutions that have had trouble were not commercial banks. Lehman Brothers, Bear Stearns and Merrill Lynch were investment banks; the American International Group is an insurance company. All four caused havoc when they teetered or, in Lehman’s case, collapsed. Any institution that is too big to fail, even if it is not in the utility end of banking, requires some sort of regulation.

Now, of course, lots of commercial banks have also gotten into trouble. Think of Citigroup or, across the Atlantic, the Royal Bank of Scotland or Switzerland’s UBS. One reason was that they invested in troubled securities. So it is appealing to think that they would have been safe if only they had not mingled the casino with the utility.

This again oversimplifies the issue. True, these “universal” banks lost money in the casino. But they also lost lots of cash through bad lending. What is more, plenty of other utilitylike institutions have been in trouble — Fannie Mae, Freddie Mac, Northern Rock in Britain, Countrywide, Washington Mutualand Wachovia. And going back a generation or so, there was the spectacular collapse of American savings and loan associations.

Yes, the casino is risky. But so is the utility. What the current crisis has shown is that the management of risk has been woeful across the board.

So the solution is not to pick on one particular banking activity — like proprietary trading — label it as risky and quarantine it in some half-regulated purgatory. The better approach is to improve risk management across the industry.

Here is hubris. The author presumes that somehow animal spirits are going to be reigned in by regulation or risk management as he euphemistically refers to it. We can have risk taking, innovation and profit or we can have state controlled enterprises, we can’t have both at the same time. They are mutually exclusive.

The point of reinstituting some form of Glass-Steagall is to bring the banks under the thumb of regulation as well as to reformat the banking industry. But we need risk takers as well and that function performs well only outside the realm of intense regulation.

The author is perfectly correct in asserting that Glass-Steagall had it still been if force would not have prevented the current crisis. But he misses the point as to why that would not have occurred.

It is not a function of a mixing of investment banking and commercial banking that brought us to this state of affairs but rather our willingness to let financial institutions grow to monolithis sizes. The conundrum we find ourselves in is one in which we have become captives of financial institutions that overwhelm our capacity to shut them down and resolve the problems they have created. Resolve it we will but the puzzle is how we prevent a recurrence of the problem.

A new Glass-Steagall that not only brings the commercial banks back to manageable size and complexity but also places the riskier elements of their activities off limits is one solution. We need the Goldmans and Morgan Stanleys of the world as well but we need them in a form that causes little dislocation when they fail.

Defending failed policies and constructs is not going to provide a reliable framework for the future.

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