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Reinforcing Glass-Steagall Won’t Prevent Another Financial Crisis


Muddled thinking about banking is ascending across the political spectrum. From Bernie Sanders and Martin O’Malley to Mike Huckabee and Rick Perry, politicians of all stripes are suggesting (or flat-out stating) that the partial repeal of the Glass-Steagall Act—the 1933 law that established the separation of “commercial” and “investment” banking—by the 1999 Gramm-Leach-Bliley Act (GLBA) gave rise to the financial crisis of 2008-09. Nothing could be farther from the truth, but there is a lot of political star power behind this populist fantasy.

Exhibit A: Senators Elizabeth Warren (D-Massachusetts), John McCain (R-Arizona), Maria Cantwell (D-Washington), and Angus King (I-Maine) have gone so far as to sponsor tri-partisan legislation entitled the “21st Century Glass Steagall Act,” which Sanders has made the centerpiece of his Wall Street “reform” agenda.

The act purports to restore Glass-Steagall—which would be bad enough—but would in fact impose constraints even more severe than the original law. Its sponsors regularly demonize the GLBA, despite the fact that one of them (McCain) voted for its passage in 1999.

To Hillary Clinton’s credit, the “glass ceiling” is not the only vitreous feature of our national architecture that her presidential campaign is inclined to smash. When the question has arisen in the Democratic primary debates, Clinton distanced herself from the pro-Glass-Steagall crowd, although her statements on the matter tend to make vague and ominous reference to a “more comprehensive approach” to financial regulation. (One does suspect, too, that her husband’s role in signing GLBA may have something to do with her somewhat halfhearted defense of the law.)

While Wall Street bears the brunt of popular anger over the events of 2008-09—some of it justified—many other streets did not exactly cover themselves in glory in the run-up to the financial crisis. Pennsylvania Avenue, Constitution Avenue, K Street, and, yes, Main Street spring to mind. Bankers and ratings agencies and mortgage originators, politicians and regulators and lobbyists, community groups and homeowners, Fannie Mae and Freddie Mac—we all have cause to repent of our manifold sins and wickedness.

There are, however, three distinguished gentlemen whose consciences should be perfectly clear: Messrs. Gramm, Leach, and Bliley. Pace demagogues of Left and Right, when it comes to the recent financial crisis, the GLBA has nothing to do with the price of tea. To see why, we’ll need to set the historical record straight and define some terms along the way.

A Historical Primer

The year is 1933, and the nation is mired in depression. Numerous American banks—roughly a quarter—have already failed, mainly the victims of bank runs. Flustered Jimmy Stewarts distribute vault cash to the panicked residents of Pottersvilles from sea to shining sea. President Franklin D. Roosevelt assumes office on March 4 and immediately declares a national banking holiday. Banks are shuttered across the country to stem the contagion.

Evidence has played little role in these debates, then as now.

Shortly thereafter, Roosevelt signs emergency legislation in hopes of restoring public confidence. On March 12, the president delivers the first of his famous “fireside chats,” which begins with the immortal words (at least to the banking bar): “I want to talk for a few minutes with the United States about banking.”

Enter Sen. Carter Glass. A rural Virginian, Glass would serve as President Woodrow Wilson’s Treasury secretary and, in 1920, receive appointment to fill a Senate vacancy. Reacting to the Great Crash of 1929, Glass fulminates against the “stock market speculative operations” of banks. He believes banks are diverting credit toward the stock market and away from more deserving sectors—agriculture, commerce, and industry, or what some are today inclined to call the “real” economy.

Specifically, Glass faults banks for fueling the bull market of the 1920s by extending margin loans to securities speculators and engaging in securities transactions on their own account. (Now, there isn’t actually much evidence that any single significant bank actually failed during the 1920s or 1930s owing to the securities activities against which Glass so inveighed, but as we’ll see, evidence has played little role in these debates, then as now.)

He believed banks were diverting credit toward the stock market and away from more deserving sectors.

Together with Rep. Henry Steagall (D-Alabama), Glass sponsors the Banking Act of 1933, a bill that would ever after bear their names in common parlance, “to provide for the safer and more effective use of the assets of banks, to regulate interbank control, to prevent the undue diversion of funds into speculative operations, and for other purposes.”

Among other things, the Banking Act of 1933 provided the Federal Reserve with expanded authority to regulate member banks of the Federal Reserve System, formally established the Federal Open Markets Committee, and, more controversially at the time if less so today, created the Federal Deposit Insurance Corporation to insure retail deposits against the risk of bank failure.

Glass-Steagall Divides Banking

The Banking Act’s best-known provisions—and those at the heart of contemporary debates—sought to achieve the “complete divorcement” of “commercial banking” from “investment banking.” These terms of art are central to understanding what Glass-Steagall did and did not do.

These mirror-image provisions were intended to inhibit the use of deposits to fund speculation in the capital markets.

A “commercial bank” accepts customer deposits and extends loans. This is your garden-variety bank, which holds your savings and checking accounts and perhaps funds your mortgage or business loan. An “investment bank” underwrites and deals in securities. These include the storied institutions of Wall Street—Morgan Stanley, Goldman Sachs, Merrill Lynch, Bear Stearns, and Lehman Brothers, R.I.P. Their role involves assisting companies in raising capital through securities issuances (e.g., initial public offerings or bond offerings). They also “make markets” in securities by buying and selling stocks and bonds, thus ensuring their liquidity on the secondary market—just as an antiques dealer makes a market in fine art or furnishings.

Glass-Steagall addressed four specific “Thou-shalt-nots” to commercial banks and investment banks. First, the act denies commercial banks the authority to underwrite or deal in securities (Section 16), excepting (ahem) federal government and municipal securities. Second, dealers in securities (except as permitted by Section 16) were barred from engaging in the business of accepting deposits (Section 21). These mirror-image provisions were intended to inhibit the use of deposits to fund speculation in the capital markets.

Third, the act prohibited the affiliation under common ownership of commercial banks and organizations principally engaged in dealing in securities (Section 20). Fourth, the act prohibited interlocks between the officers and boards of directors of commercial banks and organizations primarily engaged in dealing in securities (Section 32). One of the first consequences of Glass-Steagall, therefore, was the breakup of the House of Morgan into J.P. Morgan and Co. (a commercial bank) and the predecessor to Morgan Stanley (an investment bank).

Regulators Allow the Law to Weaken

Then slowly dawned the realization that Glass-Steagall wasn’t all it was cracked up to be. Beginning as early as the 1960s, the constraints on commercial banks were regularly relaxed by federal banking authorities at the Office of the Comptroller of the Currency and the Federal Reserve. In the face of vigorous efforts by the investment banking and mutual fund industries to impede entry by commercial banks into securities activities, the judiciary generally upheld the agencies’ interpretations.

The shackles of Glass-Steagall were harming the competitiveness of U.S. financial institutions vis-à-vis their international peers.

Over the years, commercial banks expanded the margins of their business to engage in a broader range of activities. To name a few: discount brokerage, advising mutual funds, and underwriting securities (but not as a principal activity). These developments helped to highlight that the shackles of Glass-Steagall were harming the competitiveness of U.S. financial institutions vis-à-vis their international peers, for which a “universal banking” model, combining both commercial and investment banking services, was the norm.

Over the course of the 1980s and 1990s, a consensus built in Washington that Glass-Steagall’s affiliation and interlock provisions had been overtaken by events and should be repealed. In 1999, the Gramm-Leach-Bliley Act was passed by an overwhelming, bipartisan majority of the House and Senate and signed into law by President Bill Clinton. The GLBA (or “Gleeba,” as it is typically, if not euphoniously, pronounced) left the remainder of Glass-Steagall intact, and Sections 16 and 21’s prohibitions remain good law to this day.

Here endeth the lesson.

The Populist View: Glass Half-Empty

There is no need to rehearse the causes of the financial crisis in detail. Peter Wallison of the American Enterprise Institute has done so ably in his recent volume, “Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again.” For various reasons—some of them nakedly political—the U.S. financial system generated, signed, serviced, pooled, securitized, rated, distributed, and insured a whole lot of very, very improvident “sub-prime” and “Alt-A” mortgages, these being the High Church Legalese for “loans to borrowers who are extravagantly unlikely to make good their promises to pay.”

This is High Church Legalese for ‘loans to borrowers who are extravagantly unlikely to make good their promises to pay.’

But is there any case to be made that GLBA’s partial repeal of Glass-Steagall played a hand?

Sen. Elizabeth Warren certainly thinks so. Warren’s political website solicits support for the 21st Century Glass Steagall Act, stating that “Congress passed the Glass[-]Steagall Act in 1933 to separate risky investment banking from ordinary commercial banking[, and] for half a century, the banking system was stable and our middle class grew stronger.” This sentence alone contains factual mischaracterizations, a confusion of correlation and causation, and a non sequitur.

Warren continues: “Wall Street had spent 66 years and millions of dollars lobbying for repeal, and, eventually, the big banks won.” Here we see a misstatement of the law and an ad hominem attack. To be fair, Warren conceded to New York Times reporter Andrew Ross Sorkin that “one of the reasons she’s been pushing reinstating Glass-Steagall—even if it wouldn’t have prevented the financial crisis—is that it is an easy issue for the public to understand and ‘you can build public attention behind,’” noting her belief that Glass-Steagall is “more of a symbol of what needs to happen to regulations than the specifics related to the act itself.” Cynicism and illogic: of such stuff is the case against the GLBA built.

Sen. John McCain certainly thinks so. McCain took the opportunity in his Senate speech introducing the bill to lambaste Wall Street and, presumably, his own 1999 vote for the GLBA: “Since core provisions of the Glass-Steagall Act were repealed in 1999, shattering the wall dividing commercial banks and investment banks, a culture of dangerous greed and excessive risk-taking has taken root in the banking world.” McCain would perhaps be surprised to discover that human greed and recklessness far predate 1999 and, indeed, even 1933.

Glass-Steagall is ‘more of a symbol of what needs to happen to regulations than the specifics related to the act itself.’

Sen. Bernie Sanders certainly thinks so. Sanders’s financial acumen was on display in recent remarks, when he declared that he will reinstate Glass-Steagall “within one year” of his election to the presidency. Sanders’s press release expressing support for the Warren-McCain-Cantwell-King bill is nothing if not direct: “We not only must reinstate this important law [i.e., Glass-Steagall], but we also have to break up the too-big-to-fail financial institutions in this country. If an institution is too big to fail, it is too big to exist.”

For what it’s worth, Sanders is consistent. As a member of the House of Representatives in 1999, he was one of the few to vote against the GLBA. He crows: “I was proud to lead the fight in the House against repealing the Glass-Steagall Act. I predicted then that such a massive deregulation of the financial services industry would seriously harm the economy. I would give anything to have been proven wrong about this, but unfortunately what happened to the economy during the financial collapse of 2008 was even worse than I predicted” (emphasis added).

The Populists Versus Gramm, Leach, and Bliley

Oyez, oyez, this kangaroo court is now in session, and the accused Sen. Gramm and Reps. Leach and Bliley stand in the dock. Let us grant Sanders’s wish to be proven wrong and acquit the defendants of all charges, one fact at a time.

The notion that GLBA allowed ‘fat cat’ investment bankers to play high stakes roulette with retail deposits is groundless.

Fact: The GLBA was not—repeat, not—a full repeal of Glass-Steagall, as its detractors frequently imply in remarks before the pitchforks-and-torches crowd.

Both before and after GLBA’s enactment, commercial banks have been prohibited from underwriting and dealing in investment securities. They remain so today. Investment banks are no closer to accepting deposits than they ever were since 1933. Stringent rules unrelated to Glass-Steagall prohibit investment banks from relying on funding from affiliate commercial banks, thus protecting both customer deposits and, by extension, the FDIC deposit insurance fund. The notion that GLBA allowed “fat cat” investment bankers to play high stakes roulette with retail deposits is groundless.

GLBA did permit affiliations between commercial and investment banks under a common holding company, paving the way for the development of “financial supermarkets,” and very large ones at that. The director and officer interlock provisions of Section 32 were also discarded.

Fact: GLBA did not authorize commercial banks to trade in bonds, fixed-income securities, or mortgage-backed securities for their own account—they could already do that under Glass-Steagall.

Far from precipitating the crisis, GLBA made possible the acquisitions and liquidity lifelines that saved four of the five investment banking giants.

Some commercial banks got themselves into hot water during the financial crisis as a result of holding residential mortgage loans or residential mortgage-backed securities (RMBS), whose value declined dramatically when housing values plummeted. Both were bad investments, especially where the ratings agencies assigned RMBSs spuriously high credit ratings. No argument there.

But banks could always invest in these debt securities as an extension of their lending powers. Nothing in Glass-Steagall speaks to bankers’ imprudence or ever restricted investments in mortgage loans or in highly rated RMBSs. By extension, GLBA didn’t either.

Fact: Far from precipitating the crisis, GLBA made possible the acquisitions and liquidity lifelines that saved four of the five investment banking giants.

Five “bulge bracket” investment banks were imperiled by the financial crisis. After its onset, Goldman Sachs and Morgan Stanley abandoned their status as independent investment banks primarily regulated by the Securities and Exchange Commission and converted into bank holding companies under Federal Reserve supervision. They did so largely to secure access to liquidity facilities offered by the Federal Reserve under its “lender of last resort” authorities.

Reasonable minds may differ as to whether this was an ideal outcome. But let’s not forget that the primary purpose of central banking is extending such facilities in time of financial contagion. According to a maxim of Walter Bagehot’s, lender of last resort powers are to be exercised only in exchange for good collateral from solvent institutions and at high rates of interest, to check moral hazard—this is precisely what happened in 2008-09 during the late Bush and early Obama administrations.

Far from causing the 2008-09 financial crisis, GLBA facilitated these institutions’ ultimate deliverance.

Merrill Lynch and Bear Stearns were acquired in the nick of time by Bank of America and JPMorgan, respectively—each of which was a commercial bank holding company (although each already had investment banking subsidiaries at the time). This stabilized the imperiled institutions within a diversified financial group and allowed them to weather the storm.

Each of the above institutions teetered on the precipice as an investment bank and found salvation by converting into or being acquired by a bank holding company. You guessed it: far from causing the 2008-09 financial crisis, GLBA facilitated these institutions’ ultimate deliverance.

Lehman Brothers failed. And how! But although Lehman Brothers was affiliated with a couple of small pseudo-banks known as “industrial loan companies” (ILCs), their losses were insignificant compared to the size of Lehman’s consolidated balance sheet. (Indeed, as a technical matter, the conversion of the ILC subsidiaries of Goldman Sachs and Morgan Stanley was what allowed those two giants to convert into bank holding companies, as discussed above.)

As for the rest of the dramatis personae of 2008—Washington Mutual (thrift), AIG (insurance company), the Reserve Primary Fund (money market fund), and Fannie Mae and Freddie Mac (government-sponsored havoc-wreakers)—none was even subject to Glass-Steagall or GLBA. There is not a shred of evidence—nor could there be—that the GLBA had anything to do with their fates.

Clear as Glass

The conclusion is as clear as glass: Gramm, Leach, and Bliley (and President Clinton and Treasury Secretary Larry Summers and the hundreds of other senators and congressmen of both parties who voted for GLBA) may rest assured that they didn’t provoke a financial crisis—at least as far as their decision to “repeal” Glass-Steagall is concerned.

Restoring the status quo ante circa 1999 is not only unnecessary, it’s foolhardy to try. Such a move would entail the unwinding of 17 years of financial market consolidation and yield “narrow” banks that are arguably more prone to failure, not less. Bashing GLBA may play well with the Occupy Wall Street crowd (not to mention its right-wing coadjutors), as Warren candidly notes. Let’s hope Clinton and her eventual Republican opponent put to rest the canard that simple structural fixes will cure what ails our financial system.