economics

January 18, 2010

Separating investment banks will not make us safer

Filed under: Uncategorized — ktetaichinh @ 6:06 am
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Senators John McCain and Maria Cantwell have introduced bipartisan legislation to reinstate a version of the Glass-Steagall Act, the Depression-era reform that separated commercial banking from investment banking. Mr McCain and Ms Cantwell thus join a very distinguished group of reformers, led by the estimable Paul Volcker and other notables including Nicholas Brady, the former Treasury secretary.

This group traces the origins of the current crisis to Glass-Steagall’s 1999 repeal, and would once again separate the “safe and predictable” activity of taking deposits and making loans from “risky” underwriting, trading and hedging. The new financial sobriety reflected in this proposal sees risk as the cause of the current crisis, if not the nastiest four-letter word in the English language.

But reimposing Glass-Steagall would lock our financial system in the amber of the past. The notion of recycling a solution from three generations ago, created long before globalisation, computers and the internet, and widely regarded as grossly outdated 15 years ago, even by today’s proponents of reimposition, would be laughable were it not advanced by so many otherwise serious people. But it would be a seriously flawed policy.

First, there is no evidence to support the assertion that the demise of Glass-Steagall caused or even helped to cause this recent crisis. Some argue that the large global financial institutions at the centre of the debacle could not have been created had Glass-Steagall not been cast aside. But bigness itself was not the problem. Bubbles and crashes have been with us since long before Glass-Steagall and will be with us long after as well.

Glass-Steagall was enacted in 1933, after a Senate committee investigation appeared to show that conflicts of interest inside banks allowed them to stuff worthless stock they had underwritten into their depositor/investor accounts, thereby leading to massive stock price collapses and wiping out hordes of unsuspecting investors. The New Deal reform, enacted to prohibit banks from engaging in the risky activity of underwriting, accomplished exactly that.

But this separation did not prevent the market “crash” of 1987, the savings and loan debacle of the late 1980s, the property loan problems of the banks in the early 1990s, the Asian debt crisis of the late 1990s or the internet bubble, all of which the commercial banks and other financial institutions helped to create.

The “risky activities” at the root of our recent financial meltdown were elsewhere. They were about too much lending, too much leverage, too much opacity and too little oversight. The restoration of Glass-Steagall would not address any of these. It would, however, create a bonanza for merger and acquisition lawyers and bankers to untangle the huge, global conglomerates, spark a massive and frantic search by financial professionals for the most profitable new opportunities, and consign the resulting utility-like commercial banks to a world of little capital, less talent and no creativity.

What is “too risky” for commercial banks? Underwriting? Securitisation? Lending? Was it not irresponsible lending that got us into this mess? Do we really want enormous regulatory time and resources to go into determining which bank activities are permissible, as we did in the 30 years before Glass-Steagall’s repeal?

Technology and the internet have revolutionised financial markets and led to a proliferation of new products and services. This technology should now be put to use for the public interest. Justice Louis Brandeis’s insight of over 100 years ago is still relevant: “Sunshine is the best disinfectant.” Using the internet to disclose more information to both regulators and the public will go a long way to preventing another financial catastrophe.

While there is a legitimate question as to how much risk and dynamism we need to achieve reasonable economic growth while avoiding bubbles and extraordinary shocks, restoring an outmoded law is a cure in search of a diagnosis. Let us have more transparency, better oversight, less risky compensation and better consumer information and protection. But let’s not go back to the future.

The writer is an adjunct professor at Georgetown’s McDonough School of Business and a lecturer at the Washington Campus, a consortium of 16 business schools. He was president and chief executive of the Securities Industry Association and its successor the Securities Industry and Financial Markets Association from 1992 to 2008

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