It’s impossible to look at any single financial regulation without understanding the problem it is trying to solve and how it would hang together with the rest of the financial regulatory regime. This is why cost-benefit analysis of financial rules isn’t very useful, as any rule depends on all the other rules. It also means that two people who agree on one idea for regulation could still bring about two very different worlds, one significantly worse than the other.
This has happened with Glass-Steagall, the Depression-era separation of commercial and investment banking. Both the Republicans and Democrats endorsed its return in their party platforms. But there are two ways to talk about the reform, a Left and a Right way to imagine what problem Glass-Steagall would solve and what kind of financial regulatory regime you would have after it was reinstated. I think the Right’s way is wrong, dangerously so, and would leave us with a split regulatory regime and a world very similar to 2007.
The Left’s Approach to Glass-Steagall
The Left story would argue that the risks of investment banking are so great that they put FDIC insurance at risk. The wave of losses hitting investment banks like Lehman Brothers and Bear Stearns in 2008 were bad enough, but when that wave of losses was about to hit a bank like Citigroup it became far riskier. As Barry Ritholtz described, Glass-Steagall’s repeal was “not a cause, but a multiplier” of the crisis. Imposing Glass-Steagall would reduce this spillover risk; it would also make it easier to resolve said firms in a crisis, while reducing their political power. The extent to which this is important and a priority has been debated extensively in the primary, but it is a clear story.
It follows from this story that you would extend important stability regulations to all the new, standalone investment banks created by reinstating Glass-Steagall. You’d use the designation powers of Dodd-Frank to require them to be funded with more capital and equity and prepare for how they’d handle a crisis. They’d be subject to the Consumer Financial Protection Bureau, the same consumer regulator as commercial banks. In short, you’d standardize the regulatory regime.
The Right’s Approach to Glass-Steagall
Here’s another story about Glass-Steagall: The protections around commercial banking caused the financial crisis. Federal backstops for consumer deposits mingled with normally boring investment banking to make both far riskier than they would have been otherwise. Commercial banking obligations, such as the Community Reinvestment Act, made it worse. As Thomas Hoenig argues, “A safety net was extended beyond commercial banks to bank holding companies and broker-dealers […] The Federal Deposit Insurance Corporation (FDIC) fund and the taxpayer are the underwriters of this private risk-taking [leading up to the crisis].”
I personally think the idea that FDIC insurance was responsible for the crisis is difficult to justify on any number of grounds, but the important thing about this story is that it absolve investment banking of any systemic risk. The Left’s story is about the risks investment banks pose to commercial banks; the Right’s story is about the risks commercial banks pose to investment banks. If commercial banking regulation lead to the crisis, you wouldn’t want to extend it to investment banks.
As a result, the Right’s story calls for splitting the regulatory regime and rolling back reform, which is exactly what the Republican platform does. The RNC platform makes a point of ending Dodd-Frank, including its ability to regulate investment banks, while also attacking the CFPB at length. It says the cause of the crisis was “the government’s own housing policies,” not mentioning Wall Street. Interestingly, it includes a demand “that FDIC-regulated banks are properly capitalized.” Note that this purposeful phrasing means the new investment banks would be exempt from the requirement for more capital.
The Serious Consequences
So the Right’s plan would involve creating many new investment banks while taking away Dodd-Frank’s new abilities to subject them to higher capital requirements and crisis preparation. There’d be no FSOC or SIFI designation, so no way to heighten their regulations. No CFPB to standardize consumer protection, and no tools to wind them down. In other words, it would be the world of 2007 all over again.
But there’s a deeper issue here. The crisis showed that it is difficult to draw a clear line between the risks of commercial banking and investment banking, and as such, it’s crucial to standardize the regulatory regime between the two, no matter what activities you allow any one firm to do.
I’m going to quote at length from a fascinating discussion I had with Columbia law professor Jeffrey Gordon over his new book Principles of Financial Regulations. Gordon notes that “Glass-Steagall divided the world intellectually into two distinct financial arenas, securities markets and banking. Securities markets were subject to the regulatory authority of the SEC, whose major tools were disclosure and enforcement; the banking agencies oversaw banks using a strategy of prudential oversight. Legal specialization aligned this way; so did academic work.”
However, he says, “in the ensuing decades, an increasing share of financial activity took place in the large space of functional overlap between banks and securities markets.” Since those activities were securities markets, “the principal regulatory tool was disclosure, even though the core activity was maturity and liquidity transformation, the sort of activity that we have learned from banking requires prudential oversight for stability.” He concludes that “[t]he consequence of this regulatory mismatch was a massive increase in systemic risk.”
Worse, Gordon believes that this separation helped with the development of shadow banking. “The development of market-based credit intermediation was not by chance. Glass-Steagall created a set of institutions – investment banks – that came to see that their living depended on inventive ways to use securities market for debt finance. Hence the rapid financial innovations in debt markets in the run-up to the financial crisis.” Gordon contrasts that system with the universal banks of Europe, which were slower to develop market-based debt finance.
It’s difficult to determine if Glass-Steagall is a serious policy priority for Donald Trump or not, and whether it will be in the next Republican platform. But regardless of which activities you believe the largest financial institutions should be allowed to carry out, it’s essential to ensure a unified regulatory regime. To cleave it in two, as the GOP platform would do, is to invite another disaster.