Financial Stability For Our Time: A 21st century Glass-Steagall Act

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Since the presidential campaign, President Trump has been giving mixed signals to shareholders in US banks who have no idea of what to expect from his policy positions. Donald Trump has been wavering between populist and business-friendly policies and expressed seemingly conflicting plans for Wall Street: on the one hand advocating for less regulation with a repeal of the Dodd-Frank Act and on the other hand proposing the introduction of a 21st Century Glass-Steagall Act, a law that could impose a raft of new restrictions on banks and limit their affiliation with investment banks. After having delighted bankers by saying that he “expected to cut a lot out” of the widely despised Dodd-Frank legislation, he seemed to have recently re-incorporated the updated version of the Glass-Steagall Act in his agenda.

Support for reinstating the legislation comes from policymakers of both sides. Both Democrats and Republicans believe this could reduce the risk of another catastrophic financial meltdown. Senator Elizabeth Warren (D – MA) claims that what was achieved with post-crisis regulations was not enough since big banks and large financial institutions are still threatening the global economy.

Some US policymakers are looking at Britain’s incoming ringfencing rules as a satisfactory solution in the case of a banking crisis. By 2019, UK banks will have to erect a barrier between retail and investment banking activities, by putting their retail banking units inside a heavily capitalised subsidiary, protecting them in case the group fails.

So, from financial liberalization, the debate has recently moved towards a discussion on a revival of the Glass-Steagall act but let’s look at this in the proper order.

From the Glass-Steagall act to the Volcker rule

In 1933, in the wake of the 1929 Stock Market Crash that lead to many commercial banks failures and to the Great Depression, the Glass-Steagall Act was passed. The Act main purpose was to separate commercial and investment banking due to the sentiment that commercial banks were taking on too much risk with depositors’ money. This barrier between commercial and investment banking aimed to prevent a loss of deposits in the event of investment failures. The iconic Depression-era law prevented securities firms and investment banks from taking deposits, and commercial Federal Reserve member banks from: dealing in non-governmental securities for customers, investing in non-investment grade securities for themselves, underwriting or distributing non-governmental securities and affiliating (or sharing employees) with companies involved in such activities. Apart from making banks decide whether to be commercial or investment banks, it introduced Regulation Q, which prohibited banks from paying interest on demand deposits and capped interest rates on other deposit products.

The Glass-Steagall act was the reaction to one of the worst financial crisis at the time, but it started then to be seen as too harsh by most in the financial community. This sparked a debate on whether this represented too much regulation for the industry and whether letting banks diversify would, in fact, reduce the risk. This led to the repeal of the Glass-Steagall Act.

In the 1970s and 1980s a new wave of economic thinking about the inefficiencies of government regulation translated into a deregulation process (removing or reducing state regulations, typically in the economic sphere). In the financial sector in the U.S., this promoted the Financial Services Modernization Act of 1999, which repealed part of the Glass–Steagall Act, removing barriers in the market among banking companies, securities companies and insurance companies that prohibited any institution from acting as any combination of an investment bank, a commercial bank, and an insurance company. In 1998, two deals signaled the end of Depression-era rules: Citibank and Travelers Group agreed on the merger that would create Citigroup, combining commercial and investment banking and insurance under one roof; and the merger of BankAmerica and NationsBank to create Bank of America. This also indicated the end of the American model of many small, local banks, giving rise to a world with banks “too big to fail”.

This new model crashed disastrously a decade later in the great financial crisis of 2007-8. The response to this financial crisis was the Dodd–Frank Wall Street Reform and Consumer Protection Act, a massive piece of financial reform legislation passed by the Obama administration in 2010. The main focus of this Act is to monitor the financial stability of major firms whose failure could have a major negative impact on the economy. The Financial Stability Oversight Council is also endowed with the authority of breaking up banks that are considered to be so large to pose a systematic risk or imposing additional reserve requirements. Since this Act was born due to the 2008 financial crisis, it is also concerned with strictly regulating the mortgage market in order to prevent predatory mortgage lending and to promote transparency for consumers. The most criticized part of the Dodd-Frank Act is the Volcker Rule: it restricts United States banks from making certain kinds of speculative investments that do not benefit their customers and that are believed to have played a significant role in the financial crisis. It is a ban on proprietary trading, that is, whenever financial instruments are traded with the firm’s own money, as opposed to depositors’ money, to make the whole profit for itself.

Back to the present days’ debate

The financial industry has been complaining about the capital constraints imposed by the Dodd-Frank Act and about all its complicated regulations, claiming that the Act is making lending money to real people and businesses more difficult. During the Presidential campaign the main reason brought for the repeal of the Dodd-Frank was the negative impact it has on small community banks, stating that the regulatory burden could only be absorbed by big banks.

Although there is much talk about deregulation, there may be limits to the demand for rolling back the Dodd-Frank Act, since financial institutions have spent considerable resources ensuring compliance with it and transforming the way in which they do business. As such, getting rid of the law could be costly and may not be feasible, especially if it is to be replaced with different regulations, which would require banks to overhaul their current compliance efforts. Moreover, as Janet Yellen said she “wouldn’t want to see the clock turned back” and that it would lead to an increase in the odds of a future financial crisis.

What seems more likely is for certain core provisions of the Dodd-Frank Act to be amended. Since it is often described as anti-competitive, overly complex and that it hurts market liquidity, we could witness a repeal of the Volcker Rule. Federal Reserve Governor Daniel Tarullo, despite his support for a strong capital regime, believes that the complicated Volcker rule on proprietary trading is damaging market-making activities. There is a strong relationship between the survival of the Volcker Rule and the need for a new Glass-Steagall-like separation between commercial and investment banking. If the Volcker Rule survives in a strong form, no new separation is needed. If it does not, however, policymakers and regulators will need to find a suitable replacement, that could be, among others, an updated version of the Glass-Steagall Act.

A revival of the Glass-Steagall Act would have significant consequences: although only a few banks combine both investment and commercial banking, they are all enormous, namely Citi, JPMorgan, Bank of America, Deutsche Bank and others. This Act, described by bank lobbyist as the gravest threat they face, is an effort to break up universal banks, which are so difficult to manage and monitor. The repeal of the Glass-Steagall act gave them birth and encouraged unacceptable risk-taking.

However, opponents state that a full separation would help neither the investment banking side, which would become unstable, nor the commercial banking side, which would be deprived of profitable activities, and it would increase the instability of the financial system. It would also threaten the world leading position of US banks, making foreign banks relative winners. Moreover, it could be too difficult to “unscramble the eggs” since many financial products now mix commercial and investment banking. If there was a going back to the Glass-Steagall Act it would need to be under a new light and in accordance with today’s financial system. Noteworthy is that a complete rewire of our financial system could create instability in a world that it is just getting out of a recession.




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