The Shattered Arguments for a New Glass-Steagall
Investment banking isn’t risky. What’s dangerous is creating stand-alone firms that can’t diversify.
Gary Cohn may not be the first White House official you’d expect to favor reinstating Glass-Steagall, the Depression-era law that split commercial banks from investment banks. Yet Mr. Cohn, the former Goldman Sachs president who now leads the National Economic Council, urged just that in a private meeting with lawmakers, according to Bloomberg News. This is deeply disappointing, particularly coming from an administration that seeks to stimulate growth by removing the government shackles that suppress competition and burden markets.
The 1999 repeal of Glass-Steagall was unfairly blamed in the aftermath of the 2008 financial crisis. Some people—apparently Mr. Cohn among them—mistakenly believe that investment banking is so risky that it should be once again kept separate from commercial banking. The truth is exactly the opposite: Traditional investment banking entails very little risk. The danger is stand-alone investment banks that are not diversified enough to survive a shock.
Traditional investment banks primarily underwrite debt and equity for corporations; provide advice on mergers, acquisitions and divestitures; buy and sell securities for institutions; and help clients hedge their risks. These activities involve almost no risk on the investment banks’ own books. In contrast, commercial banks extend credit to people and businesses and retain a good deal of both the credit risk and the interest-rate risk. The repeal of Glass-Steagall allowed these banks to diversify their risks and revenues by providing fee-based investment services.
Banks are at risk of failure when they become too concentrated by geography, industry or product line. Risk needs to be diversified so that no one mistake can bring down the entire institution. Even firms like Citigroup and Bank of America that made a series of mistakes in the 2008 crisis survived because they were diversified. Investment banks that were not properly diversified did not survive: Bear Stearns, Lehman Brothers, Merrill Lynch.
The major perpetrators of the 2008 financial crisis were 20 or so institutions that had originated, securitized and distributed exotic subprime mortgages with toxic features. About 10 investment banks packaged mortgages made by savings-and-loan associations such as Countrywide, Washington Mutual and Indy Mac, and by state-chartered mortgage brokers—many of which committed outright fraud. These S&Ls were the remnants of an industry that had cost taxpayers some $150 billion during the 1980s and early 1990s. Notably absent from this array of culprits were large commercial banks, with an exception or two.
Unfortunately, regulators failed to see or act on the growing problems until they had escalated into a full-scale financial crisis. The Securities and Exchange Commission failed to enforce adequate capital and liquidity requirements on investment banks, including Bear Stearns and Lehman Brothers, which had trillion-dollar balance sheets funded by volatile and expensive short-term wholesale funds.
As a consequence of the crisis, the offending investment banks and S&Ls were sold, liquidated or converted into regulated banking companies. The financial system has stabilized at historically high capital levels and the economy is growing again (albeit much too slowly).
Today there are no major stand-alone investment banks engaged in high-risk trading for their own accounts. After much turmoil and hundreds of billions of dollars in losses, they are finally gone. Investment banking now either is part of the regulated commercial-banking industry or is conducted in small boutique firms that 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.
This is a positive change for the safety and soundness of the financial system. Yet almost unbelievably, there are calls to restore Glass-Steagall, re-create stand-alone investment banks, and allow them to operate once again outside the regulated banking system. The administration and Congress should not even consider putting America’s economy at risk that way again.