Breaking up big banks through Glass-Steagall is an absurd idea

According to recent news reports, Gary Cohn, a key White House economic advisor, supports splitting up the nation’s largest banks in a manner suggestive of restoring the Glass-Steagall Act, which Congress largely repealed in 1999. Reinstating Glass-Steagall is a fundamentally absurd idea because no rational case can be made for doing so.

Glass-Steagall, enacted in 1933, forced large commercial banks to divest their investment banking activities. A pure reenactment of Glass-Steagall is highly unlikely as the financial services industry has irreversibly changed dramatically over the last 84 years, largely because of the revolutionary impact of electronic technology. In other words, the genie cannot be put back in the bottle.

{mosads}Enactment of Glass-Steagall was based on the mistaken belief that the investment banking activities of a relative handful of commercial banks were an underlying cause of the Great Depression and the failure of 9,000 commercial banks in the 1930-33 period.

Almost all of those banks, though, were tiny, largely rural banks that failed because of local economic problems attributable to the unprecedented price deflation that began in 1930. Most of these banks had just one office due to state and federal prohibitions or limitations on bank branching — their assets were not geographically diversified 

None of them were engaged in investment banking. The relative handful of larger banks that failed suffered from bad loans and illiquidity, not their limited investment-banking activities.

The great deflation of the early 1930s bottomed out and a very slow economic recovery commenced in early 1933 when the newly inaugurated President Franklin Roosevelt took the United States off the gold standard. The separation of commercial from investment banking that year did not contribute to that recovery; if anything, the separation may have impeded it.

Fast-forward to the present and the search is still on for the underlying causes of the 2008 financial crisis. Not only did housing prices crash in many areas of the United States, leading to several million foreclosures, but 523 commercial banks and thrift institutions have failed since 2008. 

None of those banks failed because they also were engaged in investment-banking activities. Instead, they failed for the classic reason banks fail — they were saddled with too many bad loans. Many of those bad loans were to homebuilders and property developers.

Separately, several investment banks failed, notably Bear Stearns and Lehman Brothers, but they did not have extensive commercial banking activities. Merrill Lynch might have failed, too, if BankAmerica had not been strong-armed by the U.S. Treasury into acquiring it. These firms were largely sunk by their mortgage-securitization activities, especially the securitization of subprime home mortgages.

What is not well understood today is the fact that the Glass-Steagall separation of investment from commercial banking had materially eroded by 1999 through regulatory actions taken by the Federal Reserve. 

Those actions were driven by the declining cost of computerization and telecommunications, which enable both commercial and investment banks to profitably arbitrage Glass-Steagall-related regulations. Consequently, each type of bank could increasingly engage in activities comparable to what the other type of bank provided.

The demarcation between commercial and investment banking became increasingly fuzzy. Glass-Steagall was dying, and cannot be resuscitated, despite fervent attempts by Sen. Elizabeth Warren (D-Mass.) to do so.  Today, many financial-services products, especially credit products and derivatives, cannot easily be classified as an investment banking or a commercial banking product. 

Another argument for separating commercial from investment banking is that it would eliminate too-big-to-fail banks. That, too, is an absurd notion, because even if such a separation could be accomplished, America would still have some very large, yet less diversified commercial banks and a handful of large investment banking firms, none of which could be liquidated quickly without causing significant economic damage to the real economy.

Too-big-to-fail is a serious public-policy issue that 2010’s Dodd-Frank Act attempted to solve through such devices as giving regulators the powers and tools to resolve a large, troubled bank through an orderly liquidation. 

To date, though, there has not been a large bank failure that would test the workability of those powers, but there is substantial skepticism of their practicality. No reasons have been offered as to why separating commercial from investment banking would enhance that workability.

Although President Trump has expressed support for bringing back Glass-Steagall, I doubt if he even understands what Glass-Steagall is, much less the complexity in trying to reenact that law. Further, many Republicans would strongly object to resurrecting Glass-Steagall — they are focused, especially in the House, on reducing banking regulations, not adding new ones.

While there will continue to be chatter inside the Beltway about bringing Glass-Steagall back, that Congress will revive a law that should never have been enacted in the first place is as likely as the fate of the proverbial snowball.

Bert Ely is the principal of Ely & Company, Inc., where he monitors conditions in the banking and thrift industries, monetary policy, the payments system, and the growing federalization of credit risk.

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