Drucker: Bring back Glass-Steagall!

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Senators Elizabeth Warren and John McCain are the Romeo and Juliet of banking legislation.

The lawmakers, one Republican and one Democrat, have joined forces to propose new legislation to revive the restrictions of the Glass-Steagall Act. Established in 1933, that law established barriers between commercial and investment banking sectors. It had already been diluted over decades and was essentially repealed in 1999.

The new proposed legislation clarifies the boundaries again: deposit-taking institutions would not be able to buy or sell securities for profit, underwrite issuances or act as investment advisors. Elizabeth Warren writes it would “leave not room for regulatory interpretations that water down the rules”.

The banking lobby has naturally sallied forth. They have encouraged the dissemination of numerous straw man articles to protest that Glass-Steagall was not was not a proximate cause of the crisis, which is in fact largely correct. They highlight that:

  • Investment banks Bear Stearns and Lehmann Brothers failed; commercial bank Washington Mutual went bust; mortgage bank Countrywide went belly up. Yet JPMorgan, which combined investment and commercial functions, sailed on to greater glories.
  • Under Glass-Steagall, Bear and Merrill Lynch could not have been absorbed by commercial banks; Goldman Sachs and Morgan Stanley could not have converted to bank holding companies.

What they miss is that the lack of Glass-Steagall made the credit crisis much worse, allowing banks to become larger, more complex and more leveraged. Money center banks like Citi bulked up, setting off an arms race.

Fed vice chairman Thomas Hoenig also notes that short-term repos and money market funds, issued by investment banks like Bear and Lehmann, were marketed to the public as ultra safe deposits, leading to the financial panic. By one analogy, the Titanic would have sunk anyhow, but more passengers would have survived with more lifeboats.

The real damage of the Glass-Steagall repeal has been the creation of a too-big-to-fail banking class, with 12 banks controlling 70 per cent of all banking assets, 30 per cent higher than five years ago.

The powerful banking lobby will doubtless quash the latest bill, to keep it that way – until the next crisis.

Vanessa Drucker is the American editor of Fund Strategy magazine