Glass-Steagall Critics Get a Little Bit Right and the Rest All Wrong

Putting a wall between commercial and investment banking is one piece of building a secure financial system.

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AIG logo from headquarter offices in Manhattan's financial district, Wednesday, Jan. 9, 2013. AIG is considering Wednesday whether the company should join a lawsuit against the government that spent $182 billion to save it from collapse.

Last month, an unlikely pair of senators proposed new legislation to strengthen the financial system. The bill, titled "The 21st-Century Glass-Steagall Act," would reinstate a Depression-era law that separated routine commercial banking from more speculative investment banking. It was sponsored by Massachusetts Democrat Elizabeth Warren, Arizona Republican John McCain and two others – a striking bipartisan alignment that drew wide notice.

Support came from the progressive left and the populist right. Opposition came swiftly from the financial industry. The main line of criticism is that the repeal of Glass-Steagall in 1999 did not cause the financial crisis, and so its reinstatement is not going to prevent a future crisis. These critics argue that some of the financial firms that failed, such as Bear Stearns and AIG, had nothing to do with Glass-Steagall, and Glass-Steagall would not have saved them.

This argument is a vast oversimplification, although it contains a tiny grain of truth. Glass-Steagall's repeal in 1999 did not, by itself, cause the financial crisis, and so its reinstatement unaccompanied by other reforms is not going to prevent a future crisis. Glass-Steagall targets one of five major issues that need to be addressed to buttress the banking system. It is designed to complement other reforms, some already enacted in the Dodd-Frank financial reform law, and others still to come.

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

At the most fundamental level, the financial collapse happened because market forces failed to discipline risk-taking by executives who lead banks and other financial firms. Under normal conditions, the fear of financial ruin is enough to make a company president cautious. But in our system, normal market discipline was suspended. Financial executives took on far more risk than they could handle. The factors that encouraged excessive risk-taking are worth restating, so we can put Glass-Steagall in perspective:

  1. Financial institutions could issue mortgages to inappropriate borrowers and then sell these mortgages right away, so they wouldn't be caught holding the bag when the payments stopped.
  2. Financial institutions were allowed to expand their speculation by leveraging their federally-guaranteed deposits. (This is what the original Glass-Steagall Act prohibited.)
  3. Capital requirements were set too low. Financial firms were not required to keep enough assets on hand to protect against speculative investments that went bad.
  4. The massive scale and interconnectedness of the financial system required the government to bail out institutions rather than let them fail due to their poor risk management. (This is the so-called "too big to fail" problem.)
  5. There was a profound misalignment of incentives between the performance of financial firms and the pay of the executives who ran them. The financial incentives for executives and boards, coupled with the lack of criminal prosecution, meant that individual executives profited personally from decisions that were catastrophic for the banks they ran.
  6. [Read the U.S. News Debate: Should Big Banks Be Broken Up?]

    Complex systems fail in complex ways. Our financial system fails in ways that resemble the crash of a large commercial passenger jet. Planes and traffic control systems are well designed now, with built-in safeguards and redundancy. A crash rarely has a single cause. Most plane crashes these days reflect a convergence of factors such as a runway undergoing repairs, a crew being fatigued, a mechanical problem and bad weather, all coming together to overwhelm the built-in resiliency and robustness of the aviation system.

    Similarly, our financial system – as large and interconnected as it is – is robust most of the time and can absorb considerable shock without collapsing. But when five major structural weaknesses converge, it is too much.

    The ability of financial institutions to speculate with taxpayer-guaranteed funds is a major cause of the crisis and it must be addressed, along with the other causes. If we don't reinstate Glass-Steagall, then we need to enact the Volcker Rule, a similar measure that was originally part of the Dodd-Frank legislation. Both Glass-Steagall and the Volcker Rule have advantages and disadvantages. The choice between the two involves both technical and political considerations. Either way, a policy solution is needed to stop financial firms from speculating with federally insured deposits. We won't have a stable financial system until we do.

    [Read the U.S. News Debate: Are Banks Becoming Too Big to Jail?]

    Meanwhile, it's important to keep in mind that reinstating Glass-Steagall won't address the other causes of the financial crisis and the Great Recession. Glass-Steagall is part of a bigger picture. Glass-Steagall doesn't address the lack of consequences to executives who wreck their banks and then ask the taxpayers to refinance the smoking ruins. And it doesn't address the sheer size and systemic importance of the largest financial institutions. (If implemented, it would force certain institutions to break up, but then other mergers would take place along different dimensions.)

    However, a new Glass-Steagall bill would complement the Dodd Frank legislation enacted in 2010. Dodd-Frank addresses most of the pieces of the puzzle that the proposed Glass-Steagall act avoids. For example, it provides for an orderly wind-down of failing financial institutions as an alternative to limitless taxpayer bailouts. Together, Glass-Steagall and Dodd-Frank provide an important bulwark to protect our financial system against future crises.

    David Brodwin is a cofounder and board member of American Sustainable Business Council. Follow him on Twitter at @davidbrodwin.

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