Thursday, November 27, 2014

Spooked by Glass-Steagall’s Ghost?

CAMBRIDGE – America’s long-controversial Glass-Steagall Act of 1933, which separated deposit-taking commercial banks from securities-trading investment banks in the United States, is back in the news. This separation long symbolized America’s unusual history of bank regulation – probably the most unusual in the developed world. 

American banking regulation had long kept US banks small and local (unable to branch across state lines), unlike their European and Japanese equivalents, while limiting their operational capacity (by barring banks from mixing commercial and investment banking). These limits on American banking persisted until the 1990’s, when Congress repealed most of this regulatory structure. Now the idea of a new Glass-Steagall is back, and not only in the US.

Sandy Weill, Citigroup’s onetime CEO, said last month that allowing commercial and investment banks to merge was a mistake. This is the same Weill who had lobbied to gut Glass-Steagall in order to build today’s Citigroup, which put insurance companies, securities dealers, and traditional deposit-taking banks all under one roof. In fact, he engineered an agreement to merge Citi with a large insurer – illegal at the time under Glass-Steagall – and then pushed for the law’s repeal, so that the merger could proceed.

A similar debate has been underway in Britain. A commission headed by Sir John Vickers, the Oxford economist and former Bank of England chief economist, wants banks’ retail operations to be “ring-fenced” from riskier trading and investment banking businesses. Ring-fencing is not exactly Glass-Steagall-style separation – Glass-Steagall forbade commercial banks from even affiliating with investment banks – but it is in the same spirit.

The impetus for the rethinking is, of course, the recent financial crisis. Are Weill and Vickers right now, people are asking, or was Weill right two decades ago, when he backed allowing investment and commercial banks to merge?

That is actually the wrong question to ask first. The first question is whether Glass-Steagall’s repeal strongly contributed to the financial crisis in the US. If it did, Glass-Steagall’s repeal should be revisited, and quickly. If it did not contribute much to the crisis, keeping risky trading away from commercial banks’ deposit base may still be desirable, but not something that the financial crisis “proved” is necessary.

Those who say that the financial recent crisis tells us to re-enact Glass-Steagall overlook what failed and what did not: the largest failures in the 2008 crisis – Lehman Brothers, AIG, and the Reserve Primary Fund – were not deposit-taking commercial banks on which Glass-Steagall’s repeal had a major impact. AIG was a mega-insurer. Lehman was an investment bank. The Reserve Primary Fund – brought down by its purchases of IOU’s from Lehman – was a money-market mutual fund, not a commercial bank.

True, major commercial banks, like Citibank and Bank of America, tottered, but they were not at risk because of their securities underwriting for corporate clients or their securities-trading divisions, but because of how they (mis)handled mortgage securities. Mortgage lending, however, is a long-standing activity for commercial and savings banks, mostly unaffected by Glass-Steagall or its repeal.

Some commercial-banking activities are closer to securities trading. The so-called “Volcker Rule,” proposed by Paul Volcker, the former US Federal Reserve chairman, is a mini-Glass-Steagall, aiming to bar deposit-taking commercial banks from derivatives trading – now seen to be a dangerous activity for them. But, again, although derivatives trading played an important role in the crisis (AIG’s inability, without a government bailout, to honor its risky credit-default swaps is the best example), Glass-Steagall’s repeal did not unleash the riskiest trades in the institutions that failed. Reenacting it will do little, if anything, to remedy crisis-related ills, beyond what the Volcker Rule is supposed to do anyway.

The best case against Glass-Steagall’s repeal is not that mixing investment and commercial banking caused the crisis. Rather, the best case arises from a general sense that financial institutions have become too complicated to regulate and too big to fail even when staying within their traditional businesses. Hence, we should simplify and strengthen them.

But even if those are the goals, the recent focus on repealing Glass-Steagall is not helpful, because it is not the most important way to simplify and strengthen America’s banks. It thereby diverts policymakers’ attention from the main issues. If the financial crisis reveals a structural problem in banking, it is more likely to come from insufficient capital to cushion a bank’s fall, or from too many financial institutions having become too big to fail.

The US Dodd-Frank legislation, enacted in 2010, did (weakly) cap the size of future bank mergers. But, if size is still the problem, more could be done. If big banks have become too complex to regulate, then a workable Volcker Rule is the best way to start simplifying them. And, if the problem is systemically risky derivatives trading in banks and elsewhere, then the priority given to derivatives traders over nearly every creditor ought to be curtailed.

Ironically, Glass-Steagall itself arose in the 1930’s from commercial bankers’ efforts to divert regulators’ attention from other remedies. Small-town bankers throughout the country wanted government-guaranteed deposit insurance, while stronger big-city banks feared that government deposit insurance would put them at a competitive disadvantage. After all, deposits from the small-town banks were running off to big banks in money centers like New York, Chicago, and Los Angeles.

Two decades ago, Donald Langevoort, now a law professor at Georgetown, showed that major bankers – indeed, the leaders of First National City, the predecessor to Weill’s Citibank – proposed Glass-Steagall in lieu of deposit insurance. No big bank was at risk from trading securities then, but the big banks’ investment-banking affiliates were not making money trading and underwriting securities during the Depression, so the banks were willing to surrender that part of their business. The irony is that Congress took up the big banks’ offer to separate commercial and investment banking, but then enacted deposit insurance anyway.

Glass-Steagall was a distraction then; it is a distraction now. If the goal is to shore up the weaknesses revealed by the global financial crisis, policymakers in the US and other countries should first look elsewhere.

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    1. CommentedTooScaredToUse MyRealName

      I allege that the truth is that much of the mortgage securitization was extra-legal. Glass-Steagal wouldn't prevent the regulatory capture at the heart of the 2008 crash.

      Start with MERS, the entity set up by the mega-banks and Fannie/Freddie specifically to circumvent state laws requiring all transactions encumbering real estate to be publicly recorded (for a now-avoided fee), thus ensuring infallible chain of title to property rights.

      There should never arise the slightest possibility that a borrower, having paid off his mortgage to the bank (Servicer) claiming it's owed the debt, could be presented an original note showing that the owner thereof was never paid. Yet, that is precisely what MERS and MBS have given us.

      MERS said that it kept equivalent records electronically, with original paperwork following within 90 days. That rarely happened, and Servicers are now unable to produce "wet ink" original promissory notes (the negotiable instruments) during foreclosures or bankruptcies, or even for mortgage satisfactions.

      And that's why robo-signing hit the news - they were reconstructing chain-of-title documents to replace the required assignments that were not contemporaneously executed in MERS with the sales of the note. Judges are setting aside mortgage debts and bankruptcy claims when this is found. Further, some borrowers have proven this fraud to their Servicers such that banks are forgiving large chunks of debt or streamlining generous modifications outside any government programs for such.

      This desperate robo-signing measure shows how desperately the MBS industry needs to hide something - its violations of securities laws.

      You see, the wet ink notes had to be gathered into Trusts. A Trust had to sell its MBS tranches and close within 90 days so the investors could receive tax advantages under REMIC. That's why MERS had the 90-day rule.

      What really often happened was that investors were sold the MBS before the Trusts owned any notes. Once investors' money was Warehoused, then Originators were sent the underwriting instructions and the mortgages were written and the notes placed into the Trusts. That means Prospectuses provided to investors were frauds. Some large investors like pension funds are litigating this.

      Given that the federal government protected big banks and AIG from their at-risk losses, it's hard to understand why the Justice Department hasn't thoroughly investigated and prosecuted these shenanigans and collected $billions. Well, sigh, maybe not so hard, given political realities.

      But think of this...suppose one could prove that his mortgage has already been paid off through TARP and QE machinations? Some few have such proof in hand. Maybe that could begin to change those political realities.

    2. CommentedJames Edwards

      Glass-Steagall Act of 1933 was designed to force separation between banking units to insure that risk does not spread to the depository institutions. The reason deposit insurance was created to protect depositors from losing their money from the closure of banks where at that time many lost everything in the ensuing Great Depression
      The financial crisis came from series of banking laws that changed the banking landscape from local to nationwide.

      In my research, I have found that the driver of it was the Commodities Futures Modernization Act (CFMA) which prohibited Federal and State regulatory agencies from using its power to investigate securities trading where many of the mortgages were bundled into securities. Furthermore it retained prohibition on State agencies from using "bucket shop" laws (set up as a result of the banking crisis in 1907) to shut it down when it became clear that it was creating systemic risk. Adding to the mix is the financial industry systematic throttle any attempt to regulate its activities.

      After Frank-Dodd Act overturned CFMA, Now we're seeing attempts by the Republicans candidates to overturn the law putting CFMA back in its place.

        CommentedCharles Broming

        The Frontline episode on the CFMA and Brookesly Born's brief tenure as the head of the CFTC and courageous, losing battle with the gang of four (Rubin, Summers, Geithner and Greenspan) to head off its passage at the pass is enlightening and infuriating.

        Your story of the motives for passing G-S of 1933, the Investment Company Act of 1940 and the act that created the FDIC is part of the larger story. As Rae discusses, it's more complicated and involved a lot of political infighting to protect the banking industry as much as possible while carving out meaningful protections for depositors and investors over an 8-year period.

    3. CommentedSiddhartha Gadgil

      The goal (as conveniently ignored by the author) is to separate that part of a banks operation that should be protected by the taxpayer from the parts that should be allowed to go bust.

    4. CommentedWayne Anderman

      Could a valid arguement be made in this case, that the mishandling of mortgage securities by the banks - from the perspective it may have been partially driven by the incentive to collect investment banking fees during the securitization of the mortgages that creates the instruments to begin with, left the banks open to moral hazards -acted upon-that could have otherwise been curtailed by Glass-Steagall being left in place?

        CommentedCharles Broming

        Yes. Such an argument would be sound as well as valid. Overconfidence in their ability to use options (all derivatives are some form of options) to mitigate real risk by reducing or eliminating financial risk and their failure to understand the difference between those risks together to with the desire to improve institutional profitability and their personal wealth drove them ignore the quality of the individual underlying loans in the mortgage bundles.
        Rae seems to miss this point, instead positing legal-structural sources for the collapse.

        Investment banking and trading activities have been far more profitable than commercial lending and retail banking since WWII. But, such "banks" were partnerships traditionally; thus, the capital at risk was the partners' personal wealth and, indeed, until the mid-1980s, all of the investment banks were privately held. Only the retail securities firms were public (Merrill Lynch, E. F. Hutton, et al.). So, the originating firms tended to be risk-averse and client-centered, focusing on raising money for their clients, finding corporate buyers and seller (M&A) and managing clients' financial assets for a fee (including trading clients' funds actively). A few (very few) firms were known as "trading firms", who engaged in "proprietary trading", among such firms Salomon Bros. was most widely known (Warren Buffet bailed this firm out with a $billion investment in the form of preferred stock with warrants for conversion into common).

        I think your insight, though narrow in scope (securitization fees only), opens a wider window into the entire modus operandi of the consolidated firms.

    5. CommentedBertrand Groslambert

      Mr Roe,

      You wrote: "American banking regulation had long kept US banks small and local" and then: "If the financial crisis reveals a structural problem in banking, it is more likely to come ... from too many financial institutions having become too big to fail."

      Contrary to your conclusion, it seems to be a good argument for the Glass-Steagall act, in the sense that it prevented US banks from being too big to fail.

        CommentedDominic Albino

        I'll echo this. Glass-Steagall kept investment and commercial banking separate, and thereby certainly kept both sides smaller.

        It is a fine suggestion that other legislation may be better able to divide over-sized financial entities, but Glass-Steagall would work in that direction and already has both precedent and familiarity going for it - not insubstantial considerations. New legislation would start from scratch.

        Will the results of brand new legislation be so much more effective to make up for the extra ground that must be covered before it can be passed?

    6. CommentedA. T.

      The purpose of Glass-Steagal (and why it is a good idea) is not to prevent financial crises. It's purpose is to prevent financial crises from devastating anyone other than financiers.