The convention platforms of both political parties call for restoring the widely discredited Depression-era Glass-Steagall Act, which separated commercial from investment banking. What could they be thinking? Have they already forgotten the causes of the panic of 2008-09?
Some people mistakenly believe that investment banking is so risky that it should be separated from commercial banking. In truth, traditional investment banking entails very little risk and certainly less than traditional commercial banking.
Traditional investment banks engage primarily in underwriting debt and equity for corporations; providing advice on mergers, acquisitions and divestitures; buying and selling securities for institutions; and helping clients hedge their interest rate, commodity and foreign-exchange risks. Investment banks accept very little risk on their books in carrying out these activities.
In contrast, commercial banks extend credit to individuals and businesses and retain a good deal of credit and interest-rate risk. Why should we prohibit commercial banks from providing fee-based, relatively risk-free investment banking services to their clients and diversifying the sources of bank revenue?
Investment banks—and commercial banks—become risky when there is a large proprietary trading and a private equity “hedge fund” inside the bank comprising a significant percentage of the revenue. This is where danger lurks, and such trading should be strictly limited and regulated.
Roughly 20 financial institutions were the major perpetrators of the financial crisis of 2008-09 and Great Recession, primarily through the origination, securitization and distribution of risky subprime mortgages. Bear Stearns, Lehman Brothers and about 10 other investment banks securitized and distributed mortgages originated by S&Ls such as Countrywide Financial, Washington Mutual , Indy Mac, Option One, First Franklin, New Century, and First Financial and by state-chartered mortgage brokers, many of which committed fraud.
These S&Ls were the remnants of an industry that cost taxpayers some $150 billion during the 1980s and early 1990s. Burn me once, shame on thee. Burn me twice, shame on me.
The majority of the borrowers under these high-risk mortgages lacked sufficient income to repay their mortgages, and a significant percentage failed to make even their first payment. A whopping 50% defaulted within a year. The scheme went largely undetected because rapidly increasing housing prices offset the cost of foreclosures.
Regulators failed to see or act on the problems until they escalated into a financial crisis. Credit-rating agencies, unbelievably, gave significant tranches of these high-risk mortgage securities a AAA rating. Fannie Mae, Freddie Mac and other government agencies insured over 70% of these risky mortgages. The Securities and Exchange Commission failed to monitor the 30 times plus leverage of the investment banks and their inadequate liquidity with trillion-dollar balance sheets funded with 90-day or less wholesale funds.
Notably absent from this array of culprits were commercial banks, with an exception or two. Yet commercial banks were and still are demonized and vilified by politicians and protesters. Congress and regulators imposed more than 25,000 pages of new regulations on commercial banks, though they clearly did not create the crisis.
The offending investment banks and S&Ls were either sold, liquidated, or converted to regulated banking companies. Our economy still hasn’t fully recovered from the crisis and yet there are already calls to restore Glass-Steagall to let investment banks operate again outside the regulated banking system.
No large stand-alone investment bank now exists, and that is a plus for the safety and soundness of the financial system. Investment banking is now either part of the regulated commercial banking industry or is conducted in smaller boutique firms that take little risk and are not highly leveraged. A separate hedge-fund industry exists for private investors interested in proprietary trading, private equity, exotic securitizations, and other high-risk businesses.
We must not repeat our extremely costly mistakes. Large, highly leveraged investment banks engaged in high-risk trading for their own accounts are finally gone. Good riddance.