Business/Finance

Glass-Steagall for Dummies: what it is and why the US needs it now

by Chris Griesedieck

I don’t know who Peter Wallison is, but he does not seem to understand the consequences of re-implementing Glass-Steagall. Or he does, and is willfully ignoring them to irritate me and appease Jamie Dimon.

Anyway, Glass-Steagall was a Depression-era, federal regulation (fully repealed under the Clinton administration after years of chipping away by banking industry lobbyists) that erected a barrier between traditional banking, such as commercial and residential loans, depositor savings and checking accounts, etc., and the more complex and risky world of investment banking. Securities firms could not have depositor accounts, and the banks could not engage in most forms of proprietary trading on their own accounts (government bonds were an exception).

There are at least two big ways that bringing back the old law would have decreased the likelihood of the most recent financial crisis, and would do much to protect the financial system (and the broader U.S. economy) going forward.

1. Incentive to Make Bad Loans

First, Glass-Steagall’s absence means that corporations participating in traditional lending can “hedge” against any potential losses on the credit they provide (indeed, on almost anything). This is because banks use securities in order to hedge, which would not be allowed under the law. Section two below explains this in more detail.

(“Just what is hedging?” I hear the collective bored reader cry. The clearest form of hedging has existed for a long time in commodities futures: a farmer will sign a contract with a buyer of corn, for example. This contract stipulates that the buyer will pay a certain price for the corn, now and until an agreed time in the future [let’s say 3 years]. Thus, the farmer is protecting herself against the possibility of a severe decrease in corn prices in the next 3 years; she is “hedging” against that potential loss. The buyer is on the other side of that transaction, and is hoping that corn prices increase during the period of the contract, so that compared to all of his competitors buying corn at market prices, he is getting a great deal on corn. Each party knows that it can lose on this deal, depending upon market conditions, but each is also mitigating its downside risk compared to not having the contract in place at all.)

Similarly, without Glass-Steagall, banks can hedge against losses on their loans. Such hedges are also often tied to future market conditions. Let’s say Why Not Bank makes a loan to a big real estate developer, Housing Prices Never Fall, Inc., that has a new condominium project. Why Not’s loan officers think to themselves, “Gee, Never Fall has always been a great client that pays down its credit lines responsibly, but we think the market for condos may actually bottom out soon. But if we pass up on this, What Could Go Wrong Bank across the street will lend Never Falls the money, and we could lose our client, and miss this opportunity. What do we do?!” So Why Not decides to lend Never Falls the money, but to hedge against any losses on the deal (see below for how they do this), just in case the market for condos does go south.

High-fives are distributed, brews are consumed, win-win, right? Not quite. Why Not may well be fine, however this deal goes. But when Why Not and other banks start doing a lot of hedging, they are creating a harmful incentive to make worse loans, increasing risk within and throughout the banking system. Over time, it becomes much easier to tell themselves, “Maybe this isn’t the safest loan in the world, what with condos selling like Red Sox hats in the Bronx, but hey, we’re covered.” The financial crisis parallel should be clear now: the lenders, as in the mortgage companies, would have been stupid not to make loans to people who were unlikely to make payments later. “Hedging” on these loans, which consisted of packaging them into complex securities for sale, made them seem safe (and highly lucrative) no matter what happened…as long as they didn’t all fail at once. But the price of homes could never go down, and that many people could never default on their mortgages, right?

The point is, when banks hedge against losses on their loans, it creates an incentive to make more risky loans, with potentially higher profits (from fees on the securities) and with far more deadly downsides. One of the reports issued by the Financial Crisis Inquiry Commission (which ultimately split along party lines and issued two reports) put it this way:

Under the radar, the lending and the financial services industry had mutated. In the past, lenders had avoided making unsound loans because they would be stuck with them in their loan portfolios. But because of the growth of securitization, it wasn’t even clear anymore who the lender was. The mortgages would be packaged, sliced, repackaged, insured, and sold as incomprehensibly complicated debt securities to an assortment of hungry investors. Now even the worst loans could find a buyer.

This problem is magnified depending on exactly how the hedging is done, and by the size of the institutions doing it, bringing us to section two.

2. Playing with Other People’s Money Becomes Playing with ALL the Money

In order to understand the ways in which Glass-Steagall helps to prevent financial meltdowns, it is helpful to break things down into two core issues: hedging as speculation (a nice word for gambling), and Too Big To Fail (TBTF).

(A) Hedging Turns into Speculation

Let’s start with how banks hedge. This isn’t really done by Tiny’s Pee-Wee Bank (though it does originate loans and allow bigger investment banks to securitize them), as much as by larger institutions that combine many other financial services with traditional lending and holding depositor accounts. Such services include investment and wealth management, facilitating sales and purchases of stocks and bonds, corporate mergers and acquisitions…pretty much everything.

Such corporations specialize (supposedly) in mitigating risk. But in many cases, they are really just pushing the risk somewhere else. Essentially, larger financial companies take a bunch of loans made by themselves, or by banks like Tiny’s, and group them into securities for sale. These are CDO’s (collateralized debt obligations). The problem with CDO’s is as stated in section 1: banks earn huge fees for packaging and selling off the loans to investors, effectively shifting the risk elsewhere, leaving less reason to use sound judgment in making loans. When those go bad, so do the securities.

The financial institutions also use credit default swaps (CDS) to hedge their risks. These instruments allow banks to insure against a default on a loan; it is basically an insurance policy. Mo Leverage Bank pays a fee to a quasi-financial-insurance company such as All In Gamblers, Inc., who agrees to pay the bank in the event that a certain security does not perform. The biggest concern with credit default swaps is twofold: they can be made on anything, whether or not the bank owns the underlying security, and they are largely unregulated. If you think buying insurance on someone else’s car sounds a lot like betting on his getting into accident, you’d be correct. Since credit default swaps can be purchased regardless of who owns the underlying security, it is just fancy gambling. Because such swaps can be done on any type of security, and because they are largely unregulated, this can lead to widespread speculation.

It is very easy for banks to say that they are just “hedging” against specific risks, when really they are speculating, since the practices appear similar. Glass-Steagall would eliminate this problem entirely by preventing banks from engaging in almost any proprietary trading, regardless if they deem it a hedge. Securities firms would still be able to engage in these riskier transactions, but not with FDIC-insured accounts.

(B) The Problem of Too Big To Fail

Finally, TBTF banks pose a systemic risk to our economy, and the Federal Reserve Bank of Dallas 2011 annual report does a good job of explaining why. Briefly, in 1970 the five largest banks comprised 17% of the total assets of the banking industry; that number was 52% in 2010. The assets of the top ten banks are now half the size of the entire U.S. GDP. Without Glass-Steagall in place, not only are the banks encouraged to continue their risky behavior, but they do so at the expense of the general public. For ultimately, it is the taxpayers who are responsible for their actions, either because of FDIC guarantees of depositor accounts within these institutions, or because when the next bust comes, there will have to be more bailouts just due to the sheer size and influence these companies have in our national economy. The re-implementation of Glass-Steagall would be an intelligent first step in the path advocated by the Dallas Fed: break up the biggest banks to decrease the extreme concentration within the industry that reduces competition and long-term stability. Just separating commercial and investment banking activities again would go a long way toward that end, and may have even made these banks too small to cause the collapse we saw in the first place.

Re-imposing Glass-Steagall will not solve our financial system’s problems, nor the broader economy’s. Wall Street also needs drastic reforms (without the loopholes lobbyists continue to place in Dodd-Frank) such as increased capital requirements, pay structures that encourage long-term strategies, and the regulation of credit default swaps on an open exchange. But for the reasons above, it is clear that Glass-Steagall can again protect this country’s financial sector from its own volatility and complacency in the face of boom markets.

Christopher Griesedieck recently graduated from Boston College with a major in history and a minor in French. He currently works as a paralegal in New York City and will enter law school at Georgetown this fall.

2 replies »

  1. Bravo! Tell your representives in Congress to co-sponsor Marcy Kaptur’s bill to reinstate Glass Steagall: HR 1489, and get it to the floor for a vote!

  2. A couple of missing pieces of the analysis. From the 70s (or perhaps earlier) commercial banks were losing their most profitable customers and lines of business from “financial disintermediation” (the wiki explanation is only so so.)

    Other, non-regulated industries were offering products (especially checking accounts and commercial loans) which were profitable to banks, and yet the competing industries didn’t bear the cost of financial “safety and soundness” regulations that the commercial banks carried. And those regs were essential to providing the only long period (50-60 years) of commercial banking stability we have seen in this country.

    Thus, because of financial disintermediation, the commercial banks were becoming ever less profitable, with shrinking ROAs and ROIs.

    The problem of decreasing profitability was becoming so bad that major banks were considering exiting the credit side of banking and providing only fee based services. (I worked for one of the super-regional banks and sat on committees studying this issue.)

    One alternative to save the commercial banks would have been to impose safety and soundness requirements on the competing industries, returning the commercial banks to competitiveness and profitability.

    With Reaganomics still warmly embraced and anti-regulatory libertarian Alan Greenspan as head of the Fed, there was absolutely no way that solution would have actually been possible.

    So repeal of Glass-Steagall seemed the only solution. What was ignored was the immense risk of combining low-risk low profit commercial banking, with its critical financial products of providing commercial credit and running the payment and import/export finance and payments systems (and with the Fed as “lender of last resort to lend stability and low credit costs to commercial banking) with the high risk high reward investment banking industry.

    More at http://rjw-progressive.blogspot.com/2010/12/red-herring-too-bid-to-fail.html

    So, if we reinstate Glass-Steagall, we have to be sure to structure the separation so that commercial banks are able to operate profitably.

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