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Reconsidering the ghost of Glass-Steagall

by Robert Teitelman | Published August 24, 2012 at 4:27 PM

Again with the Glass-Steagall. I'm well aware I'm trying the patience of whatever lonely souls are reading this in late August. But the debate over Glass-Steagall -- bring it back, consign it to the trash -- continues, in part thanks to loose comments made by Sandy Weill on CNBC, which restarted the debate in the U.S. (see my post yesterday on William Harrison's defense of big banking). Increasingly, the recurrent appeal of Glass-Steagall represents our larger inability to imagine new paths to reform. We're stuck, debating a long-dead piece of regulation while new challenges confront us. (Glass-Steagall is to the left what the gold standard is to the right.) Despite the blather, its origins are not as clear as you would think; its record is more ambiguous than the myth claims, and its lessons are more complex. It was never the clear-cut triumph it's made out to be, though it was hardly a failure either. In short, it's worth more reconsideration.

That reflection begins with a short essay by Harvard Law School's Mark Roe on Project Syndicate. Roe's piece, "Spooked by Glass-Steagall's Ghost," traverses familiar ground: Weill, the debate in the U.K. and U.S. over universal banks, the question whether the repeal of Glass-Steagall was a causative factor in the financial crisis. On that latter point, Roe gently offers up the usual objections: The real failures were not universal banks, repealing Glass-Steagall had little to do with derivatives, and re-enacting it would not have prevented the meltdown. "The best case against Glass-Steagall's repeal is not that mixing investment and commercial banking caused the crisis. Rather, the best case arises from a general sense that financial institutions have become too complicated to regulate and too big to fail even when staying within their traditional businesses. Hence, we should simplify and strengthen them." He urges boosting capital rather than bringing back Glass-Steagall.

No big surprise here. But it's in the final three paragraphs that Roe says something interesting. He launches into a consideration of the origins of Glass-Steagall, arguing that it really wasn't a necessarily rational policy designed to meet a clearly defined problem. It's worth quoting in full:

"Ironically, Glass-Steagall itself arose in the 1930's from commercial bankers' efforts to divert regulators' attention from other remedies. Small-town bankers throughout the country wanted government-guaranteed deposit insurance, while stronger big-city banks feared that government deposit insurance would put them at a competitive disadvantage. After all, deposits from the small-town banks were running off to big banks in money centers like New York, Chicago, and Los Angeles. Two decades ago, Donald Langevoort, now a law professor at Georgetown, showed that major bankers -- indeed, the leaders of First National City, the predecessor to Weill's Citibank -- proposed Glass-Steagall in lieu of deposit insurance. No big bank was at risk from trading securities then, but the big banks' investment-banking affiliates were not making money trading and underwriting securities during the Depression, so the banks were willing to surrender that part of their business. The irony is that Congress took up the big banks' offer to separate commercial and investment banking, but then enacted deposit insurance anyway."

His conclusion: "Glass-Steagall was a distraction then; it is a distraction now. If the goal is to shore up the weaknesses revealed by the global financial crisis, policymakers in the U.S. and other countries should first look elsewhere."

A quick dive into some of the academic literature further complicates Roe's historical take and provides a tonic for complaints that the jostling self-interests in the Dodd-Frank legislative process was somehow noteworthy in its seaminess. It's not. The context for the Banking Bill of 1933 was not just the Crash of '29, the collapse of the banking system and election of Franklin Roosevelt, but the Pecora hearings, which focused on self-dealing, tax evasion and speculation at the big banks. The notion that mixing securities and lending somehow put depositors' money at risk emerged from those hearings -- though the hearings never specifically demonstrated that charge. It was, in short, a moral indictment that evolved into an economic critique. True, depositors' money was lost as banks collapsed. But banks failed mostly for reasons having little to do with securities operations and more to do with mortgage and agricultural lending woes, the fragility of unit banking and the general economic collapse. As Roe points out, deposits flowed from small banks toward bigger banks, which tended to have larger securities operations. (This notion, in turn, was based on the more fundamental notion that the stock market crash "caused" the Depression.) But as Jill Hendrickson, an economics professor at the University of the South wrote in a 2001 paper examining the passage of the legislation, by 1933 securities operations even at the big banks were no longer profitable. They thus became expendable.

In a 1998 article, Alex Tabarrok, now best known as Tyler Cowen's blogging mate at Marginal Revolution, wrote a paper tracing fault lines within the big banks that opened the door to Glass-Steagall. He covers the same ground as Roe citing Langevoort but does not deal with deposit insurance. He lays out two rival camps: the Rockefeller banks (Chase and National City, a predecessor to Citigroup, and Brown Brothers Harriman) and the House of Morgan. The protagonist in all this was Winthrop Aldrich, president of Chase, son of Rhode Island Sen. Nelson Aldrich, brother-in-law of John D. Rockefeller Jr. and a major player in the founding of the Federal Reserve. The context here is complex and fascinating, including Morgan's ties to New York Fed chief Benjamin Strong and its competitive position as a powerful but thinly capitalized private bank, and the varying interests of Virginia's Carter Glass. Simply put, as the Pecora hearings ground on, Winthrop Aldrich suddenly tossed his support behind Glass-Steagall, despite the fact that Pecora never directly attacked a unified structure. Why? By doing so, Tabarrok argues, he effectively distracted attention away from Chase and toward Morgan, and he recognized that the bill would hurt Morgan more than Chase or National City, particularly through its ban on interlocking directorships. Glass originally had not wanted to regulate private banks like Morgan. With Aldrich lobbying, he now came under pressure from the Roosevelt administration to do so. (Fun fact: Glass and Roosevelt initially opposed deposit insurance as well.)

What does this mean beyond the fact that politics and policymaking is very messy? It certainly says nothing about the efficacy of Glass-Steagall once it was finally passed, though it undercuts the notion that the legislation is the solution to some sort of original sin of banking. In a 2009 paper, Harvard Business School's David Moss took a broader view of the New Deal financial reform regulation, including the banking bill. He points out what can't be denied: The New Deal produced the longest stretch of stability in banking in U.S. history, some 50 years. The trouble is, how do you separate out discrete elements like deposit insurance from investment and commercial banking or the disclosure reforms at the Securities and Exchange Commission? "One reason the American financial system performed so well over these years is that financial regulators were guided by a smart regulatory strategy, which focused aggressively on the greatest systemic threat of the time, the commercial banks, while allowing a relatively lighter touch elsewhere. This approach made sense because most financial crises up to the Great Depression were essentially banking crises. ... Notably, the strategy was not devised by any person or group, but rather arose out of the workings of the American political system, which required continual compromise and accommodation."

Note Moss' "of the time." Institutions, practices, climates change. Moss traces the beginning of the end of that New Deal regime to 1980, and the first legislation deregulating thrifts. In fact, the stresses on commercial banks from disintermediation began at least a decade or so earlier, exacerbated by the interest rate swings and recessions of the '70s. But Moss' larger conclusion does make sense. "Although certain deregulatory initiatives may have contributed to the financial crisis of 2007 to 2009 [among them, one assumes, repealing Glass-Steagall], more importantly was a deregulatory mindset that impeded the development of effective regulatory responses to changing financial conditions. In particular, the explosive growth of major financial institutions, including many outside of the commercial banking sector, appears to have generated dangerous new sources of systemic risk."

Moss' larger point is that we need enhanced regulation generally -- and to move away from the belief that the root cause of all problems is the government. That was advanced by the free-market beliefs that emerged fully in the '80s, including the kind of public-choice analysis (that is, a focus on private-interest politics) Tabarrok employs in his Rockefeller-Morgan paper. Somehow in all this there needs to be some balance between state and market. Neither is perfect; neither is fatally flawed. To paraphrase Roe, Glass-Steagall is a distraction whose origins are shot through with self-interest and whose efficacy as a panacea, even in its heyday, is unclear. We can do better. - Robert Teitelman

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