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One more time: A return to Glass-Steagall?

by Robert Teitelman | Published June 12, 2012 at 1:09 PM

Glass-Steagall just won't go away. In the Financial Times Monday, University of Chicago Booth School of Business professor Luigi Zingales (who has a new book out) confesses that he has changed his mind about Glass-Steagall. Zingales has swung from skepticism about separating commercial and investment banking, to growing conviction of the need for "a mandatory separation." He is not exactly burning with passion for the New Deal legislation. He dislikes, he says, restrictions on contractual freedom; he's well aware that the institutions that caused the biggest problems in 2008 were either pure investment or commercial banks, or neither (AIG); and while he believes there are better ways to deal with excessive risk taking in banks, "We must not allow the perfect to become the enemy of the good." Well, there's very little perfect or good on any side of this debate.

Zingales offers three reasons to bring back Glass-Steagall. First, it's the easiest way to reduce risk taking in depository institutions. The Volcker Rule, he declares, won't work. Two, it's a lot simpler than the Volcker Rule -- 37 pages versus "298 pages of mumbo jumbo." (One can agree with him on that one, while still believing that if Glass-Steagall returned, the enabling legislation would be more than 37 pages. A lot of this "mumbo jumbo" has to do with the increased complexity of finance and financial products, and the intensity of the lobbying.) Three, and most interesting, is that Zingales says he "realized it was not simply a coincidence that we witnessed a prospering of the securities markets and the blossoming of new ones (options and futures markets) while Glass-Steagall was in place, but since its repeal we have seen the demise of public equity markets and an explosion of opaque over-the-counter ones." His explanation for this gets a little convoluted. Glass-Steagall, he says, deprived investment banks of "access to cheap funds (in the form of deposits), forcing them to limit their size and the size of the bets." This boosted the number of market participants, he insists, increasing liquidity. When Glass-Steagall was repealed, investment banks "exploded in size and so did their market power." The result: New financial instruments began to trade in opaque over-the-counter markets, "rather than a well-regulated and transparent public market."

Zingales also thinks Glass-Steagall made the economy more resilient and helps restrain the political power of the big banks, because it created conflicting institutional interests.

There's little bits of validity strewn throughout these arguments. It's true, a fragmented system with different interests will limit political clout; that's one reason it took so long to repeal Glass-Steagall in the first place. The resilience argument is compelling but a relic. His evidence for this is based on the '87 market crash and the fact that "the economy was unaffected because commercial banks were untouched by plummeting equity prices." Well, that's a new one. I thought Alan Greenspan's decision to pump liquidity into the market had something to do with the market recovery -- and the fact that stock prices rebounded quickly enough to limit any permanent damage, even if banks had had to take a temporary hit on equity holdings. Zingales then notes that securities markets helped to relieve the credit crunch of the 1990-'91 banking crisis (that was the one triggered by bad commercial real estate and highly leveraged transaction lending) because they were unaffected -- "separated" -- from the crisis. Zingales claims that was not the case in 2008.

All of this involves a confusing and questionable interpretation of the economic history. The early-'90s banking crisis hardly compares to the leveraged-amplified, subprime-triggered global implosion of 2008. Zingales ignores the reality that after 1975 the securities markets mushroomed in size and diversity, taking a larger and larger share of financial transactions. Commercial banks quickly lost ground, certainly through the '80s and into the '90s. Both banking crises of that period -- the S&Ls and the early-'90s big-bank woes -- stemmed from commercial-bank lenders faced with a public-equities environment demanding higher returns, mounting numbers of nonbank competitors and a difficult macroeconomy (high interest rates) felt they had to take on risk. Zingales, like so many folks nostalgic for Glass-Steagall, ignores the specter of disintermediation: market-oriented investment and nonbank banks peeling off the most profitable product lines from commercial banks. Don't forget, while the Federal Reserve was hollowing out Glass-Steagall in the '90s, it was only repealed at the end of that decade. Consolidation and capital accumulation on both sides of the divide were already accelerating. (And why did the Fed do that? Perhaps for ideological reasons, but also because traditional banks and bank lending were the Fed's lever over monetary affairs. As the banks lost ground so too did the Fed.)

Is there evidence that the repeal of Glass-Steagall, as Zingales tries to lay out, drove the creation of increasingly opaque, over-the-counter markets? He offers none, at least in this op-ed. All that he suggests is an arguable correlation and a rickety theory. And the trouble with the theory is that he ignores any number of other factors -- Fed policy, deregulation, globalization, the drive and logic of financial innovation, the macroeconomy and the pressure to generate earnings -- and instead piles all the blame on, yes, the repeal of Glass-Steagall. OTC derivatives markets were exploding in size and sophistication by the early '90s. True, credit default swaps didn't take off mostly because they hadn't been invented yet; but the creation of an extensive OTC derivatives infrastructure (building off those future and options markets he praises) on a global scale -- supplementing the number of "powerful" Wall Street dealers, by the way, were any number of universal European banks -- was well advanced while insurance agents and small banks were still effectively blocking the repeal of Glass-Steagall.

In effect, Zingales is taking Greenspan, the bank and securities regulators, and the market ideologues off the hook and blaming it on over-mighty Wall Street firms. But his solution does not resolve anything. Even if Glass-Steagall had remained, it's quite likely the markets would have evolved in the same general direction. For one thing, the rest of the developed world lacking Glass-Steagall was involved in this market evolution. Second, Zingales' notion that the lack of deposits would have held Wall Street firms back is belied by the fact that major firms (that is, those that didn't merge with commercial banks) lacked substantive deposit bases in 2008 or (for the survivors) today. Goldman, Sachs & Co. is clearly too big to fail but has no deposit base of cheap funds. It can use its own capital, which is much more robust than before Glass-Steagall was repealed (or before it went public), and it can fund itself cheaply in the markets, and thus do pretty much what it wants. That flexibility and freedom of action has nothing to do with repealing Glass-Steagall. And beyond those firms, hedge funds such as Long-Term Capital Management, Soros, Citadel, Fortress or any number of others don't seem to need branches and deposits to prosper and make remarkably large bets, often in opaque markets like dark pools. How would they fit into a 37-page return to Glass-Steagall? And really, aren't the flaws of the public markets bigger than the repeal of Glass-Steagall? Doesn't the rise of private equity, the Spitzerian separation of research and banking, the rise of activism and the burdens of public governance have something to do with that?

The issue here is not that financial firms don't need to be regulated and restrained. They undoubtedly do. But to pretend that we live in the same world as 1933 is crazy. Glass-Steagall's time was up; it probably should have been repealed. But that repeal should have been accompanied by a deeper understanding of how we had gotten to that point, how the world had changed and how to channel the enormous forces already building up in the global financial system. Instead, we embraced deregulation in a promiscuous fashion. We're threatening to go down the same path when we ransack the history of the past 40 years to defend a piece of imperfect legislation that was fated to crumble of its own weight. - Robert Teitelman

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