I have to admit that I was not a big fan of the forced separation between investment banking and commercial banking along the lines of the Glass-Steagall Act in the US. I do not like restrictions to contractual freedom, unless I see a compelling argument that the free market gets it wrong. Nor did I buy the argument that the removal of Glass-Steagall contributed to the 2008 financial crisis. The banks that were at the forefront of the crisis – Bear Stearns, Lehman Brothers, Washington Mutual, Countrywide – were either pure investment banks or pure commercial banks. The ability to merge the two types was crucial in mounting swift rescues to stabilise the system – such as the acquisition of Bear Stearns by JP Morgan and of Merrill Lynch by Bank of America.
Over the last couple of years, however, I have revised my views and I have become convinced of the case for a mandatory separation.
There are certainly better ways to deal with excessive risk-taking behaviour by banks, but we must not allow the perfect to become the enemy of the good. In the absence of these better mechanisms, it makes perfect economic sense to restrict commercial banks’ investments in very risky activities, because their deposits are insured. Short of removing that insurance – and I doubt commercial banks are ready for that – restricting the set of activities they undertake is the simplest way to cope with the burden that banks can impose on taxpayers.
The Volcker rule, which prohibits banks from engaging in proprietary trading but allows them to put their principal at risk, is not a good substitute. Proprietary trading is when a bank invests in stock hoping that its price will go up. A bank engages in principal trading when it buys a stock from a client as a service to that client, who wants to unload his position quickly. The difference is therefore one only of intentions, which are impossible to detect, since any transaction involves two consenting parties.
The second reason why Glass- Steagall won me over was its simplicity. The Glass-Steagall Act was just 37 pages long. The so-called Volcker rule has been transformed into 298 pages of mumbo jumbo, which will require armies of lawyers to interpret. The simpler a rule is, the fewer provisions there are and the less it costs to enforce them. The simpler it is, the easier it is for voters to understand and voice their opinions accordingly. Finally, the simpler it is, the more difficult it is for someone with vested interests to get away with distorting some obscure facet.
The third reason why I came to support Glass-Steagall was because I realised it was not simply a coincidence that we witnessed a prospering of securities markets and the blossoming of new ones (options and futures markets) while Glass-Steagall was in place, but since its repeal have seen a demise of public equity markets and an explosion of opaque over-the-counter ones.
To function properly markets need a large number of independent traders. The separation between commercial and investment banking deprived investment banks of access to cheap funds (in the form of deposits), forcing them to limit their size and the size of their bets. These limitations increased the number of market participants, making markets more liquid. With the repeal of Glass-Steagall, investment banks exploded in size and so did their market power. As a result, the new financial instruments (such as credit default swaps) developed in an opaque over-the-counter market populated by a few powerful dealers, rather than in a well regulated and transparent public market.
The separation between investment and commercial banking also helps make the financial system more resilient. After the 1987 stock market crash, the economy was unaffected because commercial banks were untouched by plummeting equity prices. During the 1990-91 banking crisis, securities markets helped alleviate the credit crunch because they were unaffected by the banking crisis. By contrast, in 2008 the banking crisis and the stock market crisis infected each other, pulling down the entire economy.
Last but not least, Glass-Steagall helped restrain the political power of banks. Under the old regime, commercial banks, investment banks and insurance companies had different agendas, so their lobbying efforts tended to offset one another. But after the restrictions ended, the interests of all the major players were aligned. This gave the industry disproportionate power in shaping the political agenda. This excessive power has damaged not only the economy but the financial sector itself. One way to combat this excessive power, if only partially, is to bring Glass-Steagall back.
Original Source: http://www.ft.com/cms/s/0/cb3e52be-b08d-11e1-8b36-00144feabdc0.html#ixzz1xUPD8eUt