Tuesday, March 10, 2009

Questioning the Case for Return of Glass-Steagall

UPDATE and further thoughts below and here

MaxedOutMama observed that former Fed Chair Paul Volcker urged re-instituting a division between commercial banks and investment banks. Such a decision would reverse the 1999 Gramm-Leach-Bliley Act, which itself up-ended the separation between commercial and investment banks mandated by the Glass-Steagall Act of 1933. MaxedOutMama agrees with Volcker, downplaying my questions about the rationale for repeal.

M_O_M is one of my favorite bloggers, and knows much more about finance than me. So perhaps she's right. But I don't think she's yet made the case, because she hasn't shown either that Glass-Steagall would have prevented (or lessened) the meltdown or that re-instituting the 1933 law would reduce the odds of a repeat.

The case for a return to Glass-Steagall depends on a claim Volcker explicitly makes--that forbidding affiliation between commercial and investment banks would help "avoid another crisis like the U.S. is experiencing." I understand that M_O_M agrees, based on these statements:
[A]llowing financial companies to be in the insurance business, the securitization and investment selling business, plus own the banking side (taking deposits and writing loans), plus verticalize (the holding company owns investment houses, banks, mortgage origination, servicing, and even insurance) destroys the independence of decision making. . .

The primary reason for the enhanced risks to a financial system that involves vertical lines of production and conglomerated functions is that it destroys counterparty checks and balances.
There are several holes in this assumption, especially the fact that the financial institutions that failed, or had to merge to survive, or were bailed out included stand-alone commercial banks, stand-alone investment banks, entities whose parent owned both sorts of banks and non-bank entities--no single banking model flopped.

Moreover, neither M_O_M nor anyone else to my knowledge has claimed that any particular company failure was caused by the fact that an investment bank was affiliated with a commercial bank (or visa-versa). To the contrary, some argue that Gramm-Leach-Bliley actually moderated the effect of the crunch by permitting bank consolidation that would have been unlawful under Glass-Steagall.

MaxedOutMama does cite some specific evils that contributed to the current crisis. One is "corruption in the ratings firms," with which I agree, but which has nothing to do with--and would not be cured by--any separation between commercial and investment banks. Another is "securitizations in the last decade." I note that securitizations predated the Glass-Steagall repeal. But the important point is that re-separating commercial and investment banks wouldn't stop investment banks from buying securitized mortgages: buying securities, including securities made up of mortgages, is investment activity, not commercial banking. Gramm-Leach-Bliley didn't legalize it and returning to the status quo ante wouldn't stop it a second time.

The specific evil of the current environment that MaxedOutMama mentions the most appears to be over-integration of banking functions. She critiques, "the conglomeration of business lines," which I take to mean horizontal integration, and objects to circumstances where financial institutions are over "verticalize[d] (the holding company owns investment houses, banks, mortgage origination, servicing, and even insurance)," arguing that either "destroys counterparty checks and balances [and] the independence of decision making."

She's right that counterparties wound up being overly-reduced, the supposed rationale for TARP. But is that because of Gramm-Leach-Bliley?

To some extent, this objection is related to the previous point. M_O_M says:
[T]he investment banks, toward the end, got directly into the mortgage bank.

It was mortgage brokers, selling to non-bank firms (in many cases the worst offenders were owned directly by the investment banks) that pushed the whole business to the riskier and riskier side of things.
As noted above, however, investment banks didn't enter the business of mortgage banking. Instead, what they did was buy securities that were made up of colateralized mortgages. This isn't commercial banking and wouldn't have been prohibited by Glass-Steagall line-of-business restrictions. M_O_M implicitly concedes this by mentioning "non-bank firms" and mortgage brokers, neither of which are commercial banks, and neither of which would be forbidden to investment banks were Gramm-Leach-Bliley overturned.

Similar reasoning applies to M_O_M's point about insurance. She mentions insurance in the context of "financial companies," including "monoline bond insurers." But many of them aren't banks, and so unaffected by the relation between commercial and investment banks--for example, AIG, a non-bank outside the scope of Glass-Steagall.

It's true that Gramm-Leach-Bliley expanded the ability of regulators to authorize Federally Chartered banks to offer insurance, directly and through non-bank subsidiaries. Yet, M_O_M doesn't link that additional authority to the current crisis. Put differently, she doesn't explain how allowing commercial banks to sell insurance--regulated, like all other insurers, but state insurance agencies--undermined either "counterparty checks and balances" or "independen[t] decision making." And, per force, she doesn't say why re-instituting a prohibition on commercial bank insurance offerings would prevent the next meltdown.

Finally, MaxedOutMama complains that the current regime allows the investment bank to:
get[] profit from virtually every step in this process. When one leg of it fails, it can plausibly argue that it is merely moving money from one arm to another.
I assume she's not saying that Gramm-Leach-Bliley allows fraudulent self-dealing, which is now and has always been illegal. Rather, she seems to be claiming that the repeal of Glass-Steagall made investment banks more dependent on their sister commercial banks, and possibly the reverse. I question whether this is true. Even for entities that owned both commercial and investment banks under the current law, the two were run as separate profit centers, if not separate subsidiaries. I doubt that investment bankers--famously compensated in large part by bonuses--could be incentivized by the activities of a commercial bank sister company. And, to the extent investment bankers in once part of the company could look for offsetting profits from other investment bankers elsewhere in the same company, a return to Glass-Steagall would change nothing.

Conclusion: This post is link-light, both because of a lack of expertise and a lack of time. So, I'm not saying MaxedOutMama is wrong. Instead, I'm saying that the case for a return to Glass-Steagall depends on a showing that it would have avoided, or moderated, the current financial crisis and/or reduced the risks of an instant replay. And I don't understand the connection. Thus, while I appreciate her detailing why she agrees that Volcker is right, I don't so far follow the logic, and don't yet see sufficient facts.


With a night's sleep, I note that the post is written from the perspective of an investment bank. The point of G-S is to prevent commercial banks with taxpayer-funded deposit insurance from making risky investments. I'm not sure that re-instituting a separation between commercial and investment banks would have helped, but preventing commercial banks from entering non-depository business might. Wachovia bank, for example, was brought low by its purchase of of Golden West Financial Corp. of Oakland, which had issued "option ARMs" ultimately worth little. Would that new direction for Wachovia have been prevented by Glass-Steagall?

The discussion continues here.


Lame-R said...

Excellent points, I await MOM's response with interest.

Philip said...

I suppose the government response to the crisis from two administrations was to bail out most but not all too big to fail companies and that is where Glass-Steagall would have helped. Perhaps the government would not have felt so compelled to give/lend money if the institutions were smaller and not have such high impact.