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Sen. Carter Glass (D-Va.) (L) and Rep.
Henry Steagall (D-Ala.). |
The Democratic candidates in the last debate seemed to agree that the American banking system needs fixing.
- Sen. Bernie Sanders argued that the erosion of the Glass-Steagall wall between commercial banks and financial speculators was the setting for the 2008 financial meltdown. I think he is right on the mark, although NPR Fact Check (Jim Zarroli) questioned Sanders and Washington Post Fact Checker Glenn Kessler gave Sanders three pinocchios for saying on January 5 that "Glass-Steagall banned commercial banks from making loans to investment banking firms to facilitate their trading in the shadow-banking arena." This suggests that we need to get more of a consensus on what Glass-Steagall actually did.
- Former Secretary of State Hillary Clinton has presented a series of proposals to fix Wall Street, although she got two pinocchios for saying "[E]verybody who’s looked at my proposals says my proposals are tougher, more effective, more comprehensive" than Democratic presidential candidate Sen. Bernie Sanders’s. Fact Checker Michelle Ye Hee Lee says: "[T]he Sanders campaign has now compiled a list of 60 experts and counting, backing his plan over Clinton’s.”
As voters, we need to understand what the argument is about. The stock market's collapse since the beginning of 2016 may be in part a sign that the slow implementation of Dodd-Frank reforms is opening up re-emergence of fear about our financial system.
We have not done since 2008 the thorough-going financial market fixup that FDR and his GOP Treasury Secretary William H. Woodin and the Chairman of the Senate Appropriations Committee, Senator Carter Glass (D-Va.) undertook in 1933.
Glass-Steagall's Goal: Fix the Mix!
An easy way to remember what Glass-Steagall did is that it was designed to Fix the Mix, i.e., to end the mixing of speculative and deposit-taking activities.
One place to begin is to remember what FDR and Secretary Woodin faced when they opened for business in Washington on Saturday, March 4, 1933.
Most banks had been closed the day before, by order of state governments. Some were bankrupt. The public was panicked about the financial markets. They were afraid that they would never see their bank deposits again. Some of them unfortunately turned out to be right about that.
Then FDR declared a "bank holiday". He closed all the banks for the coming week, and then later extended the holiday for some of the banks. Treasury Secretary Woodin personally supervised round-the-clock printing of greenbacks, complete with cinematic coverage, while teams of his Treasury bank examiners looked at every bank and decided which ones would be pronounced solvent and opened up and which ones would be closed and liquidated, with depositors forever losing full access to their funds.
Meanwhile, House Banking Chairman Rep. Henry Steagall, Democrat of Alabama, carried water for the banks. The banks desperately wanted deposit insurance to prevent future panics and reassure the public and allow the banks to get back to the business of making money. Steagall proposed deposit insurance, and eventually the law created the FDIC and got insurance,
initially only up to $2,500 per depositor.
Roosevelt and his Treasury Secretary were at first totally opposed to this deposit insurance. They wanted regulation of the kind that Sen. Glass proposed, a strict prohibition against banks putting at the disposal of investment banks any of their depositors' funds. Sen. Glass correctly worried that deposit insurance might open up complacency about how banks were investing their money. They all understood that government-enabled insurance of bank deposits would leave the banks free to speculate with depositors' funds because depositors would no longer be afraid of their bank going broke.
Roosevelt, Woodin and Glass were induced to support limited Federal assumption of banking risks in return for Steagall's agreeing to
support legislation that Sen. Glass had introduced, creating a wall between banks and speculative financial institutions. Sen. Glass was seeking to protect the Federal Reserve System he had helped create in 1913, when he had Steagall's job. They were all interested in restoring faith in financial markets. At this time, Adolf Hitler was gaining ground in Germany because of the crash of 1929 and the inability of the financial markets to get back on their feet.
The Glass-Steagall Act (the Banking Act) of 1933 had two main parts. One was deposit insurance. This was gradually extended from $2,500 per depositor to $250,000 per account. The other half of the Glass-Steagall bill was regulation of securities firms and separation of investment banks from commercial banks. This that was gutted between 1950 and 2002, especially in 1999.
Glass-Steagall was about protecting the henhouse assets of FDIC-insured banks from foxes selling speculative securities and generally engaging in risky forward transactions (futures and options). Glass-Steagall was about putting a wall between the humdrum business of taking deposits from consumers and making secured loans back to them, and the risky business of speculating in business equity and debt.
Glass-Steagall split apart two groups of financial institutions–commercial banks and investment banks. Investment banks underwrite and place securities (debt and equity) and they engage in transactions of two kinds:
- A passive role, helping someone that wants to reduce their risk.
- An active role, entering the market with the intent of gambling. In this role, they are creating risks, and the more they disguise a deal to minimize the significance of risks in a transaction, the more dangerous their activity to systemic stability.
Glass-Steagall was designed to reduce market risks in two ways.
- It provided federal deposit insurance, which reduced the risks for both the banks and their depositors. The banks really wanted this, because when FDR took office the entire banking system was shut down by risks that went sour.
- It provided for bank regulation to limit the risk to the Federal Government.
The law was strict. No existing mixing of investment banking and deposit-taking banks was permitted by Glass-Steagall. There was no "grandfathering".
Bank Lobbyists' Goal: Add to the FDIC and Mix the Fix!
What has happened since Glass-Steagall?
For the first 50 years, the banks have sought to beef up the Steagall side, to greatly expand Federal deposit insurance. The deposit insurance half of Glass-Steagall has not been eroded; on the contrary:
- Federal Deposit Insurance Corporation (FDIC) coverage has been beefed up more than 100-fold. The limit has steadily increased from the original $2,500 per depositor to $250,000 per deposit account.
- Depositors are now allowed to have more than one covered account (sole, joint, custodian etc.), multiplying the coverage further.
- Beyond that, the FDIC for efficiency reasons in practice avoids the costly litigation involved in liquidating a bank and instead tries to negotiate takeover over its assets and liabilities by a solvent bank, which in effect means 100 percent coverage of deposits.
Starting under President Reagan, Congress has been
mixing the fix, dismantling protections put in place by FDR, Woodin and Glass in 1933, in the name of "modernization". These moves, culminating in the 1999 Gramm-Leach-Bliley Act,
lowered the walls between the banks and non-bank institutions, without a corresponding increase in regulation of non-bank financial institutions. When Gramm-Leach-Bliley was passed, the
Economist magazine in 1999 expressed concern that deregulating the banks without a broadening of oversight of non-bank institutions of the kind that Britain had undertaken in 1997 was inviting trouble. The
Economist was right.
Requiems for Glass-Steagall
1. Warren Gunnels, Sanders’s chief policy aide, is quoted by Glenn Kessler of the
Washington Post: "[C]ommercial banks played a crucial role as buyers and sellers of ... credit-default swaps, and other derivatives. This would not have happened without the watering down of Glass-Steagall in the 1980s and the eventual repeal of Glass-Steagall in 1999."
2. Brookings Fellow Phillip Wallach agrees that Citicorp could never have become such a megabank without Gramm-Leach-Bliley: "That is the best arrow in the Glass-Steagall revivalists’ quiver. Citibank deposits were attached to Citibank bad investments, and Citi was the Too-Big-To-Fail-iest of them all."
3. James G. Rickards, former general counsel of the Long-Term Capital Management hedge fund which was brought down by a "black swan," agrees with Sanders that the 1999 law was a bad one and that there was an important cultural shift after Glass-Steagall was repealed. Previously, he said, such shadow-bank loans required permission from the Federal Reserve under rule 4(c)(8). "The presumption was it was illegal unless the Fed said you can do it. After Glass-Steagall, we didn’t have to ask permission, and it enabled the banks to do what they wanted."
4. Camden R. Fine, chief executive of the Independent Community Bankers of America, favors a restoration of Glass-Steagall. He notes that Lehman owned a federally insured industrial loan company (ILC) that held insured deposits: "[T]he repeal of Glass-Steagall gave both commercial banks and investment banks who owned ILCs much greater flexibility to deploy their capital and their deposit funds to whatever purposes they wished, and those firms leveraged themselves many, many multiples of times more than they would have been allowed before."
5. Former Federal Reserve chairman Paul Volcker supports the idea that eliminating the Glass-Steagall separation of commercial and investment banking allowed for a trading mentality to take hold at some banks.
6. Harvard B School Prof. David A. Moss in 2009: "[T]he success of New Deal financial regulation [may have] contributed to its own undoing. After nearly 50 years of relative financial calm, academics and policymakers alike may have begun to take that stability for granted. Given this mindset, financial regulation looked like an unnecessary burden."
7. Former Federal Reserve Chairman Alan Greenspan said in October 2008: "Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief."
8. John Reed, former Chairman of Citigroup, wrote recently in
The Financial Times that the Glass-Steagall wall between banks and investment banks was needed: "As is now clear, traditional banking attracts one kind of talent, […] in many important respects, risk averse. Investment bankers and their traders are […] comfortable with, and many even seek out, risk and are more focused on immediate reward. In addition, investment banking organizations tend to organize and focus on products rather than customers. This creates fundamental differences in values."
