Glass-Steagall Redux

October 21st, 2009 - No Comments

The New York Times reports today that former Fed Chair Paul Volcker’s call to forbid commercial banks from mixing with investment banks is falling on deaf ears within the Obama administration.  Volcker, head of the president’s Economic Recovery Advisory Board, believes keeping banks from owning and trading securities will keep them out of the trouble they have experienced in the current recession.

According to Smeal’s Jean Helwege, Volcker’s plan would likely make future economic crises less costly than this most recent one, however, it won’t keep the Fed from spending taxpayer dollars to bail out poorly run banks in the future.

More from Helwege:

Paul Volcker, former Federal Reserve chairman and adviser to President Obama, recommends that we go back to the good old days when commercial banks and investment banks were kept separate. The logic now, as it was in the 1930s when Glass-Steagall was enacted, is that investment banking is too risky a business to mix with consumer deposits. In a speech earlier this fall Volcker stated, “I do not think it reasonable that public money—taxpayer money—be indirectly available to support risk-prone capital market activities simply because they are housed within a commercial banking organization.” Volcker recognizes that his views are hardly “progressive,” noting that “people say I’m old-fashioned and banks can no longer be separated from nonbank activity.”  But he points out, “That argument brought us to where we are today.”

The $64,000 question is whether we would be where we are today had we pursued different regulatory policies leading up to this recession. Whatever the policies regarding mergers of banks and investment houses, we would have experienced a housing bubble and it would still have popped, bringing massive losses to homeowners across the nation and a retrenchment in homebuilding that would last years. Fannie Mae and Freddie Mac would still be in conservatorship, having overleveraged themselves to peddle the American dream of home ownership. Investors would still have lost money on mortgage-backed securities built on subprime mortgages. Those losses would still have led to concerns that safer mortgages might default, expanding the breadth of losses in the MBS market. We would be in a deep recession as a result of the housing downturn regardless of whether banking activities are segregated.

However, Volcker’s arguments are more geared toward preventing the next near-Great Depression and redefining the policy responses to such crises. If we still had Glass-Steagall, we would not have seen the merger of JPMorgan Chase (a bank) with Bear Stearns (an investment bank) in 2008, which might have prevented people from expecting a similar deal with Lehman and some other commercial bank and thus the fallout when Lehman was dropped like a stone from the list of firms “too big to fail.” If we still had Glass-Steagall, Goldman would never have decided to convert to a bank holding company and potentially would not have received the largesse it did. Nor would Bank of America have had its arm twisted into acquiring Merrill Lynch. Bringing back Glass-Steagall might bring us back to the days of more narrowly defined policy responses by the Federal Reserve. And it might mean that the next crisis will not be worse than today’s now that the investment banks are so strongly encased in the regulatory womb of the Federal Reserve.

Reinstating Glass-Steagall is a simple response to a complex issue.  While simple may be all we can swallow, it remains the case that the Federal Reserve has not been successful in striking a balance between helping out the economy and condoning bad behavior by financial firms.  The Fed identified AIG as strong enough to get a loan (i.e., the Fed was sure it would get paid back) and Lehman as incapable of repaying new funds. It deemed CIT too unimportant to deserve aid but was willing to help out the entire money market mutual fund industry. The Fed’s willingness to extend its hand to all manner of poorly run firms is a concern and Volcker’s efforts to rein in this independent agency may help, but unfortunately it’s more likely that the Fed will find another way to expand its role as lender of last resort regardless of whether we revert to Glass-Steagall.

Tags: Banking, Economic Crisis, Finance, Helwege, Politics

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