Structural Reform Beyond Glass-Steagall

October 13, 2015

Glass-Steagall (GS) has become a central part of the debate over financial reform in the 2016 election. Several commentators have portrayed it as a central objective of financial reform, verging on a litmus test for those who are serious about the topic.

My opinion is that reinstating GS isn’t an important goal for financial reform. I don’t think the story it tells is the one we want to tell, and the reforms it would bring aren’t particularly effective. I think in terms of structural changes, there are better aspirational objectives for the debate to focus on and better options for achieving those objectives. In particular, breaking up the banks through higher capital requirements would meet the same goals while building on the work that has been done—work that is already showing significant success and could use more of a spotlight. Since this is a live debate among financial reformers, I want to explain my thoughts on this topic.

The Case for Glass-Steagall

Let’s start with the case for GS. In doing so, we should separate the role that repealing GS played leading up to the financial crisis from why reinstating GS would be a good idea now. While the repeal is important as a symbol of the deregulation of the time, it isn’t a guide for future policy. I see three broad cases to be made for GS:

The first argument is that when crises do happen, the situation will be far worse without GS. The analogy that I like to use for why the repeal of GS mattered in the 2008 crisis is that it was like keeping oily rags in your house. By themselves, oily rags won’t cause a fire. But if there is a fire, oily rags ensure you have a much bigger problem on your hands than you would otherwise.

There was a wave of mortgage-backed security losses hitting investment banks like Lehman Brothers and Bear Stearns in 2008, which led to the financial crisis. That was bad, and the banks’ quick and sudden failures caused a panic. But when that wave of losses was about to hit Citigroup, which also had hundreds of billions of dollars in deposits, the potential for disaster was much greater. This is in line with Barry Ritholtz’s description of GS repeal as being “not a cause, but a multiplier.” I think this is the right argument to focus on for GS.[1]

The second is that reinstating GS would break up the banks, if not by size then by business lines. This would lead to a less top-heavy financial sector, which would help eliminate Too Big To Fail (TBTF) and weaken the clout of Wall Street.

The third is that GS is a structural change to the financial markets. Restoring it would weaken the political and economic power of the largest banks beyond just making them smaller. This is partly because of a kind of separation of power; a fragmented financial system would be at odds with itself and unable to exert a unified influence on lawmakers and the economy. It is also because GS is self-enforcing, so it wouldn’t require intervention by regulators prone to capture.

The General Case Against

My general thought since the crisis has been that we should be extending the regulatory environment of commercial banking to shadow banking. (Shadow banking here being the funding of assets that are credit-risky and illiquid, traditionally the work of commercial banks, through short-term wholesale funding that is prone to runs.) Shadow banks’ lack of a proper regulatory infrastructure, from consumer protections to a resolution plan, created a panic and a crisis. The goal, then, should be to expand that regulatory structure out into shadow banking while weakening the economic and political power of the largest players.

I don’t think reinstating GS would help with this. If separating investment banking from commercial banking split the regulatory structures, it would be a move in the wrong direction. If it didn’t, it’s still not clear that there would be much to gain for all the energy spent. Let’s get into specifics.

Too Big To Fail

Building on the oily rags/multiplier argument, I think the most promising case for GS that hasn’t been developed is that it is necessary for ending Too Big To Fail. The case for GS is roughly the same case as where it was in 2010, yet whether or not it is feasible to ever actually put a megabank into bankruptcy or an FDIC resolution, allowing it to fail with limited economic chaos, has become one of the central focus points.

This is important because the FDIC’s major policy response, a process known as Single Point of Entry (SPOE), is designed to interject at the holding company level in a way that bypasses the institutional structure. So it won’t matter as much whether investment banks and commercial banks are in the same firm.

SPOE has been oversold, but many people worth noting have applauded it. Sheila Bair has argued that it’s gone quite a bit of the way to ending TBTF. David Skeel called it “quite promising,” which is telling since he wrote a 2010 book which basically argued that Dodd-Frank was like fascism—except worse, because the trains wouldn’t even run on time. (As was the fashion of the time, there was a lot of yelling about Obama’s “corporatism.”)

Around 2013, I tried to find the best case that GS was necessary for a financial firm to go into bankruptcy or FDIC resolution successfully. I couldn’t find a detailed argument, and the arguments I did find were much less compelling than arguments for higher equity requirements or the treatment of derivatives in bankruptcy.

Systemic Change

On the third point, would reinstating GS offer political benefits beyond breaking up the banks? I don’t find the argument that the political strength of the financial sector would be weaker under GS convincing. Some of the most powerful players before and after the crash are predominantly investment banks. Finance has done an excellent job coordinating allies against reform, be they end-users fighting derivatives or generic commercial banks fighting credit and debit card regulations. Worse, rarely has a part of finance stepped up to support weakening another part of finance. The solidarity in finance is amazing. So I don’t see a “separation of powers” in finance being a serious political constraint.

If we are thinking of structural changes as a means of focusing debate, I think there are more promising options to pursue. If we’re reaching, why not reach for derivatives? Banning “naked” credit default swaps, or more generally requiring that a party have an insurable interest in a derivative transaction, would align it with insurance rather than speculation and drain out that part of finance. It would put the focus on wasteful activity that shows no sign of abating.

I also think the “self-enforcing” part is oversold. As this timeline points out, regulators who believed the financial sector could regulate itself had been weakening GS for decades before it was finally repealed. The Volcker Rule, which should also have a clean, demarcated line, shows us that institutional design is essential, and that we won’t be able to escape the necessity of the administrative state.

Breaking Up the Banks

If the goal is to break up the banks, the best way to go about it is by instituting higher capital requirements. We are one serious surcharge on systemically important financial institutions (SIFIs) away from JP Morgan and Citigroup having to size down, just as tightened SIFI scrutiny made GE sell off GE Capital. There’s been significant intellectual work done to move expert opinion and build the case for higher capital requirements, and that work needs to be brought to the public by politicians in this election. So far, it’s not getting that energy behind it.

One of the brilliant insights from the neoliberal political project is that if you want to do something brutal that politics won’t sustain, you have “the market” do it. Can’t destroy Medicare? Turn it over to the market it and give people coupons for it that slowly die out. Then it is seen as a natural outcome, even if “the market” here is just the continuation of politics by other means.

This was the insight on financial deregulation from Greta Krippner’s excellent Capitalizing on Crisis, and we can turn that logic on its head. Higher capital will cause “the market” to break up the banks unless they can justify why they should remain the same size. Proving that they are adding value at their current size would be a high hurdle to clear. It would put pressure on size in a way that politicians, even in 2010, didn’t come close to doing directly. (The amendment for breaking up the banks got 33 votes during Dodd-Frank—nowhere near 50, much less the 60 required to beat a filibuster.)

This is the right path forward, and it’s one that should be front and center in the debates.

[1] I see the case for the multiplier story; however, I don’t see a compelling case for the repeal of GS making the mortgage crisis worse. I don’t see how it was a major driver of subprime mortgages, private-label securitizations, the web of CDS and CDOs, and the subsequent wave of foreclosures. Much of this activity was already exempt from GS. To the extent that someone could put a number on the multiplier effect in these cases, I can’t imagine it would be large.

Indeed, this is one of the reasons we can assume that most of the people peddling stories about the Community Reinvestment Act causing the subprime and foreclosure crisis aren’t serious. As was noted right away, virtually all of this lending took place outside traditional commercial banks that have to comply with the CRA.