The big financial news from late last week was a bipartisan proposal from Senators Elizabeth Warren and John McCain (and others) to bring back the Glass-Steagall portion of the Banking Act of 1933 (“Glass”). This has been tossed around since the 2008 financial crisis. If you’re not familiar with Glass, I’ll explain it briefly for you.
During the Great Depression, after numerous bank failures and the failure of other financial institutions, Congress enacted Glass to separate financial institutions which held customer deposits from those that sold stocks and other securities.
The notable portions of the Banking Act of 1933, which is referred to colloquially as Glass, are as follows:
Section 16 banned national banks (that is, banks regulated by the Office of the Comptroller of the Currency) from dealing in securities. So, say, Wells Fargo couldn’t go buy some cattle futures for its own profit.
Section 20 banned state-chartered or national banks that are Federal Reserve members from being affiliated with companies that are “engaged principally” in securities-dealing.
Section 21 banned companies that primarily deal with securities from accepting deposits. So a standalone investment bank or hedge fund couldn’t just start a side-project that offered checking accounts.
Section 32 banned Fed member banks from sharing corporate board members with companies “engaged principally” in securities-dealing.
The Gramm-Leach-Bliley Act, signed by President Clinton after a concerted lobbying effort by Republicans and Democrats (including former Wall Streeter, Treasury Secretary, and potential Fed Chairman Larry Summers) repealed sections 20 and 32 of Glass, which permitted holding companies to own both securities firms and commercial banks, and for the two kinds of companies to share directors on their boards.
J.P. Morgan Chase, for example, has both J.P. Morgan Chase Securities, and Chase Manhattan Bank, N.A. as affiliates. The former sells stocks and bonds, while the latter provides retail and business checking services.
So — with that introduction out of the way — what’s all this talk of a 21st Century Glass about? It’s an attempt to address “Too Big To Fail.”
Basically, people blame banks for the financial crisis. They are concerned that if a big bank takes a big risk with depositors’ money they could bring down the financial system if they are on the wrong side of the trade. This is of special concern because, due to consolidation and mergers, the top few big banks hold trillions of dollars of Americans deposits. Hence, the phrase “Too Big to Fail,” which means in times of trouble, the federal government would backstop or bail out banks with extremely large deposits in order not to undermine the whole banking system and cause a bank run. These banks are “Too Big to Fail,” so the government will not let them fail.
It is a fair concern, because nobody wants a trillion dollar of “risk-free” deposits of Americans wiped out because someone at Citibank has a “whale” trade of their own.
Senator Warren’s proposal, by Senator McCain’s own admission, would not prevent “Too Big to Fail:”
The legislation introduced today would separate traditional banks that have savings and checking accounts and are insured by the Federal Deposit Insurance Corporation from riskier financial institutions that offer services such as investment banking, insurance, swaps dealing, and hedge fund and private equity activities. This bill would clarify regulatory interpretations of banking law provisions that undermined the protections under the original Glass-Steagall and would make “Too Big to Fail” institutions smaller and safer, minimizing the likelihood of a government bailout.
“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,” said Senator John McCain. “Big Wall Street institutions should be free to engage in transactions with significant risk, but not with federally insured deposits. If enacted, the 21st Century Glass-Steagall Act would not end Too-Big-to-Fail. But, it would rebuild the wall between commercial and investment banking that was in place for over 60 years, restore confidence in the system, and reduce risk for the American taxpayer.”
So what’s the point, if the “New” Glass would not prevent Too Big To Fail? More regulation.
Well, dear reader — I am sure you know how I feel about more regulation. It just does not work.
How do I know this? Well, these institutions got around the “old” Glass before the official repeal in 1999.
The irony is lost upon Senators Warren and McCain with respect to the failure that is Dodd-Frank. The statute was passed in 2010 and the rules still have not been fully written. The rules, like nearly all statutes and regulations that come from the federal government, will favor the largest institutions over smaller and mid-sized institutions. Moreover, companies are taking actions so as to not be subject to the Dodd-Frank regulations.
Regulations don’t work because companies find ways around them. Why? Profit motive.
The motive for profit brings out more ingenuity than any group of government regulators could possibly muster.
So, how do we achieve what the 21st Century “Glass” allegedly wants to achieve: reducing the potential damage from Too Big to Fail?
Simple: remove the federal backstop from these banking institutions and make them liable for their actions.
No bank that is responsible for its actions would allow itself to use 40x leverage on a trade, where a decrease of 2.5% in the asset would be a 100% loss of principal, if it knew it was fully on the hook for its trades.
Moreover, removing federal backstopping will force consumers to actually investigate where they are keeping their money and other assets. Rather than just assume “the government protects me,” the individual needs to do his or her own due diligence to ensure the institution is trustworthy.
Personal responsibility. Corporate responsibility. Nice concepts, right?
As always, free markets are better markets.
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Notable Financial Happenings This Week:
It’s earnings season for some of the big banks, including Citicorp, Bank of America, and other companies like Coca-Cola, Johnson & Johnson, and Intel.
Initial Jobless Claims come out Thursday, July 18. We’ll see if last week’s spike was an anomaly. The projection is 344k, down from 360k.
Retail Sales, CPI, and Housing Data will also be coming out this week.