Wall Street's Weak Arguments Against a New Glass-Steagall

The financial industry's case against a new Glass-Steagall Act doesn't hold up.

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When Elizabeth Warren, D-Mass., and John McCain, R-Ariz., get together, it gets noticed. In partnership with Sens. Maria Cantwell, D-Wash., and Angus King, I-Maine, they have introduced a bill, the "21st Century Glass Steagall Act," notable both for its substance and as a call to action on one of the great unaddressed challenges of financial reform: the trend of accelerated concentration that has left us with an industry dominated by a handful of giant, multi-purpose, dangerously opaque and conflicted institutions far too caught up in speculative games to attend to their rightful job of supporting investment and entrepreneurship and broad prosperity.

Like its New Deal-era namesake, the bill would erect a wall between traditional banks and the risky world of investment banks and hedge funds. Their proposal updates the original law in thoughtful ways, by, for example, barring bank involvement in a range of dealer, trading and derivatives market activities, while preserving the ability of banks to engage in traditional trust and fiduciary roles.

21st century finance needs such a law for the same reasons 20th century finance did: to prevent bankers from using insured deposits and other taxpayer-supported advantages to enrich themselves; to reduce the conflicts of interest that encourage the mislabeling and overmarketing of high-risk investments; and to keep banks from leveraging their power and pivotal economic role to encroach on the territory of non-financial businesses or simply to overcharge their customers.

[See a collection of political cartoons on the economy.]

Wall Street has settled on a simple line of attack: Glass-Steagall, industry leaders and lobbyists insist, would not have prevented the financial meltdown of 2008. Indeed, the four Senators have not advertised their proposal as a magic bullet, eliminating the need for such measures as stronger capital and leverage rules and more transparent derivatives markets.

But there is a lot that it could do. Insiders without an immediate material stake in the question argue that a strong Glass-Steagall law could have limited the scope and damage of the meltdown, much as better compartments could have saved lives on the Titanic. Former Citigroup co-CEO John Reed, for one, believes "we would've hit the iceberg anyway," but the flooding "might not have spread throughout the whole ship."

The critics point out that pure investment banks such as Lehman Brothers and Morgan Stanley were in the vanguard of the bad practices propelling the financial system toward disaster. But the lines between commercial and investment banks had been badly eroded by decades of deregulation, spurring competition from commercial banks that helped drive investment banks into the dangerous business of making long-term financial commitments with deposit-like instruments and other kinds of short-term debt.

In any case, the rationale for this legislation goes beyond safety. It would gradually require the biggest banks to downsize along functional lines. By removing some of the artificial advantages of enormous size in finance, Warren-McCain-Cantwell-King would create new running room for institutions, including many community banks and credit unions, that have stuck to the old-fashioned model of taking in deposits and giving out loans – only to lose more and more business to the six megabanks, which now hold double the assets of numbers seven through 50 combined. And since small businesses often don't get much respect from big banks, "Anything that tilts the playing field back toward smaller financial institutions is good for the small business sector," Simon Johnson of MIT points out.

[Read the U.S. News debate: Should Big Banks Be Broken Up?]

Like another bipartisan measure – the bill introduced by Sens. David Vitter, R-La.,and Sherrod Brown, D-Ohio, to set higher capital requirements for the biggest banks – Warren-McCain-Cantwell-King reminds us of a long lineage of free-market conservatives, going back all the way to Adam Smith, who have advocated strong regulation of the financial sector, not just because of its propensity for panics tending to cause wide and prolonged economic distress, but also because of its importance as an element of core economic infrastructure.

The original Glass-Steagall Act was a response to the specific misdeeds that produced the banking industry collapse of early 1933. But, in reining in an overly reckless and powerful industry, it bore the influence of a tradition of reform measures that, from the Interstate Commerce Act on, had required companies with a role in running the essential networks of the economy to stick to one line of business and provide even-handed service to all.

Under Glass-Steagall, banking became more boring and less profitable. The bankers of the 1930s didn't welcome that prospect any more than today's bankers do. But they lived with it, quite comfortably, for a long time, and so did the country as a whole. In fact, Glass-Steagall was part of a body of financial regulation that stands as one of the great success stories of American public policy, giving us half a century without major bank failures and contributing to a period of unprecedented growth and prosperity which saw the emergence of a middle class that was the envy of the world.

As banking becomes more boring again, we might just see a burst of enterprise and ingenuity where we really want it – in the real economy instead of the financial economy.

Jim Lardner is the communications director at Americans for Financial Reform, a coalition of more than 250 civil rights, consumer, labor, business, investor and other groups working for a strong, stable and ethical financial system.

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