Glass-Steagall Revisited

Reformers are calling for Washington to bring back the wall of separation between commercial and investment banking to make the financial system safer. Critics say it will weaken U.S. banking competitiveness and deliver less credit for consumers and businesses.

 

Mortgage Banking

February 2016

By Robert Stowe England

 

 

The idea first surfaced in the wake of the financial crisis of 2008. And it has demonstrated surprising staying power by slowly gaining a following in the years since the crisis.

 

It is a powerful idea in part because it provides a more easily understood explanation for a complex financial crisis--perhaps the worst in American history--and offers a clear and simple regulatory recipe and remedy to avoid another crisis that could be as bad or even worse.

 

It is also a movement with advocates who have devoted considerable time and energy to making a case for the idea.

 

What is the idea? It’s Glass-Steagall--the 1933 law that separated commercial banking from investment banking.

 

Central to this cause is that the original Glass-Steagall Act ushered in an era of U.S. banking stability unrivaled around the world that lasted more than 65 years. This stability reigned even as the reach of the law was gradually eroded over the years by banking regulators, the courts and Congress.

 

Further, advocates say, the 1999 repeal of Glass-Steagall ushered in an era of risky activities by banks and Wall Street that led to the crisis of 2008. (The repeal was part of the Gramm-Leach-Bliley Act.) Since the root cause of the crisis has not been addressed, it is argued, the banking system remains vulnerable to a repeat of that crisis, perhaps on a larger scale, unless and until Congress enacts a new Glass-Steagall.

 

“The repeal of Glass-Steagall violated the fundamental rule of life that if it is not broke, don’t fix it,” says William Black, associate professor of economics and law at the University of Missouri at Kansas City and former banking regulator during the savings-and-loan (S&L) crisis. “Glass-Steagall worked brilliantly for decades. There was no need to remove it,” he says.

 

For some, the obvious remedy for the mistake of repealing the law is to bring back Glass-Steagall, according Nomi Prins, distinguished fellow at Demos, a public policy organization based in New York.

 

“Since the repeal of the original Glass-Steagall, the trading component of banks has grown and along with it, so has the inherent risk in the system,” she says. If Congress were to enact a new Glass-Steagall law, it would make for a safer and sounder banking and financial sector because “it would reduce overall risk that has grown in the system and the hazards associated with that risk,” she adds.

 

The idea of reinstating Glass-Steagall got a fresh boost on Nov. 11 in an op-ed in The Financial Times of London by John Reed, chairman and chief executive officer (CEO) of New York-based Citicorp from 1984 to 2000.

 

“The universal banking model is inherently unstable and unworkable,” Reed wrote, making clear he also questioned Europe’s embrace of universal banking. “No amount of restructuring, management change or regulation is ever likely to change that.” Reed again called for reinstating Glass-Steagall’s separation of commercial banking and investment banking, as he has done repeatedly since 2010.

 

It was the 1998 merger of Citicorp with Hartford, Connecticut-based Travelers Group that paved the way for Congress to repeal Glass-Steagall. In 2000 Reed lost out in a power struggle with Citigroup Co-Chairman Sandy Weill, the former chairman and CEO of Travelers, and left the company. In the ensuing years, Reed has lamented the merger as a wrongheaded decision and faulted Citigroup’s performance since the merger as a terrible disappointment.

 

In July 2012, Weill joined Reed in questioning the wisdom of abandoning Glass-Steagall--even though he lobbied hard for its repeal. In an interview on CNBC’s Squawk Box, he suggested it would be a good idea to reinstate the law and split off investment banking from commercial banking once again.

 

Political landscape

 

Support in Washington for Glass-Steagall II remains fairly modest and concentrated within the Democratic party. Yet, say the advocates, the need to take action grows more urgent as the financial sector continues to consolidate in the wake of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

 

“The biggest banks are collectively much larger than they were before the crisis, and they continue to engage in dangerous practices that could once again crash our economy,” stated Sen. Elizabeth Warren (D-Massachusetts) last July 7 when she and other co-sponsors reintroduced the 21st Century Glass-Steagall Act. It was originally introduced in 2013 after Warren’s election to the Senate.

 

Warren’s proposal to bring back Glass-Steagall is also sponsored by Senators John McCain (R-Arizona), Maria Cantwell (D-Washington) and Angus King (I-Maine).

 

Two contenders for the Democratic party’s presidential nomination--Vermont Independent Bernie Sanders and former Democratic Maryland Governor Martin O’Malley--favor reinstatement of Glass-Steagall.

 

The Democratic frontrunner, former Secretary of State Hillary Clinton, is not in favor of bringing back Glass-Steagall, according to one of her advisers, Alan Blinder, a Princeton economics professor who was a member of former President Bill Clinton’s Council of Economic Advisers, and a former vice chairman of the Federal Reserve.

 

Blinder told Reuters last July 11 that he had spoken to Hillary Clinton about Glass-Steagall following a speech she had given that day on economic policy, and she had conveyed to him her opposition to reinstating it.

 

Warren’s efforts to bring back Glass-Steagall have so far failed to garner significant bipartisan support beyond McCain. For example, Sen. Richard Shelby (R-Alabama), chairman of the Senate Banking Committee, who voted against the repeal of Glass-Steagall in 1999, has not signed on to support any new legislation to reinstate it.

 

Volcker Rule

 

Support for the repeal of Glass-Steagall derives in part from unhappiness by some with the Volcker Rule, which bars insured banks from engaging in proprietary trading. The Volcker Rule is named for its chief proponent, former Fed Chairman Paul Volcker, also chairman of the board of the Economic Recovery Advisory Commission in the early years of the Obama administration. The rule is part of the Dodd-Frank Act and was designed to curb risking-taking by insured depository institutions.

 

Disappointment with the effectiveness of the Volcker Rule was articulated by former Federal Deposit Insurance Corporation (FDIC) Chairman Sheila Bair, a Republican, in a December 2011 op-ed she penned for Fortune.

 

Bair called the Volcker Rule “a 300-page Rube Goldberg contraption.”

 

In the wake of the collapse of the $41 billion MF Global derivatives and commodity brokerage firm, she asked whether anything in the Volcker Rule could have prevented the activities that occurred within that firm from occurring within an affiliate of a commercial bank. Her concern arose from the fact the Volcker Rule has exceptions to the ban on proprietary trading for investment banking and market making.

 

Bair suggested that the contours of the Volcker Rule are so murky that regulators might not find it an effective tool for monitoring financial institutions. She recommended that they instead look to see whether the economics of a given type of trading activity represent a bet on the direction of the markets. If they do represent such a bet, then the activity should not be allowed.

 

Yet even this approach worried Bair. “Complex rules are easy to game and hard to enforce. If regulators can’t make this work, then maybe we should return to Glass-Steagall in all of its 32-page simplicity,” she wrote.

 

Warren’s proposal

 

Legislation championed by Senator Warren amends the Federal Deposit Insurance Act to prevent an insured depository institution from either being or becoming an affiliate of any firm engaged in underwriting and trading in securities, swaps and insurance.

 

The bill, as written, bars from the board of directors of a commercial bank any individual who is an officer, director, partner or employee in securities, swaps or insurance firms. It gives banks five years to allow for an orderly termination of prohibited activities and affiliations. Federal banking regulators can give banks another six months at their discretion.

 

Under the Warren proposal, banks are barred from investing in structured and synthetic products tied to the value of securities, commodities, swaps, indexes or baskets composed of such financial instruments. However, the legislation allows banks to continue to hold interest-rate swaps. Warren was unavailable to comment on the legislation.

 

Support for reinstating Glass-Steagall is much stronger in the House of Representatives than in the Senate. A bill sponsored by Rep. Marcy Kaptur (D-Ohio), titled the Return to Prudent Banking Act of 2015 (H.R. 381), was introduced in 2013 and eventually gained 125 co-sponsors. The bill was reintroduced in January 2015 and so far has 69 sponsors. No action has been taken on the bill by Republican leadership.

 

The Kaptur bill, which is supported by Public Citizen, Ralph Nader’s Washington, D.C.-based consumer rights advocacy group, and such labor organizations as the AFL-CIO, gives banks only two years to split off investment banking from commercial banking. It also bars banks from holding interest-rate swaps.

 

The American Bankers Association has fundamental objections to both the Warren-McCain bill and the Kaptur bill, according to Wayne Abernathy, executive vice president for financial institutions policy and regulatory affairs. “It’s based on this idea that if you just go backward to this golden time for banking that everything will be fine,” Abernathy says. “Well, there never was a golden time of banking in the history of the United States.”


Throughout U.S. history banks were always part of the economy and subject to the business cycle, Abernathy explains. “It’s hard to find a time when banks were just great and there were no problems,” he says.

 

Abernathy contends that Glass-Steagall had negative consequences for banking and the economy by shrinking the banking sector and pushing innovation outside regulated banks.

 

In the decades after Glass Steagall “the growing financial needs of the economy were increasingly being met outside the banking system and the U.S. banking system was becoming steadily irrelevant,” says Abernathy. To remedy this, regulators whittled away at the heart of Glass Steagall by permitting banks to do more and more activities that would be considering investment banking, he argues. “By the time Gramm Leach Bliley was enacted, it didn’t do anything new. It basically codified what the regulators had accomplished with some help from Congress.”

 

Deposit insurance

 

A central argument for splitting off investment banking from traditional banking is that deposit insurance may subsidize and promote riskier behavior in investment banking than would occur in its absence. Under this view, only when investment banking is separated from commercial banking will the disciplines of the market act to better regulate riskier activities in investment banking.

 

“It’s fairly obscene that you could own a business and get a federal subsidy, and compete with others who don’t get that subsidy,” says the University of Missouri’s Black.

 

“Yet under universal banking, you get to own commerce and you get to compete with others that do not have the express subsidy of deposit insurance or the implicit subsidy of being one of the systemically important institutions--the so-called too-big-to-fail institutions,” he says.

 

Black is disappointed that free-market critics of Glass-Steagall do not share his views about the subsidy provided by deposit insurance.

 

“Providing these subsidies distorts the markets, and that is harmful as well,” he says.

 

Humpty Dumpty

 

Opponents of Glass-Steagall say arguments to bring back a separation between commercial and investment banking are not persuasive. They view Glass-Steagall as a sort of regulatory Humpty Dumpty that, once broken, cannot be put back together again.

 

“Basically it is very difficult to see how you could separate the investment banking function of a variety of companies from their traditional banking functions,” says Richard Bove, equity research analyst at Rafferty Capital Markets LLC, New York.

 

“The markets have moved on from the situation in the 1930s. Therefore, to replace that and go back to the 1930s makes little sense,” he says.

 

If Glass-Steagall’s separation of commercial and investment banking were to be restored, it would have a devastating effect on American banking and the U.S. economy, according to Bove.

 

“The U.S. is losing market share in global finance,” Bove says.

 

“There are four banks in China that are larger than the biggest bank in the U.S. The largest of the four, the Industrial and Commercial Bank of China [ICBC], is the biggest bank in the world and has profits greater than JPMorgan and Wells Fargo put together,” he says.

 

“What we’re seeing is a rapid shift in wealth, a rapid shift in control of the financial system. And if the U.S. decides it wants to have a bunch of S&Ls and bunch of small brokerage firms as their method of competing in the world financial system, you can just close the door on the United States being a financial giant in the world,” says Bove.

 

“You can also close the door on major projects in the U.S. getting funded, because the Chinese are going to fund the projects in China, Thailand and Cambodia. The United States drops to the sidelines,” he adds.

 

Black thinks arguments about losing competitiveness are missing the point. “The German universal banking model is a disaster and, in any event, that view represents a competition in laxity,” he says.

 

“The only winning move is to not play” in a competition to have the most lax form of banking regulation, he says, echoing a line from the 1983 science-fiction movie War Games. It would be far better for the United States to lead the world, as it has, in promoting a strong and resilient banking and financial sector, he maintains.

 

FDIC Vice Chairman Thomas Hoenig, an advocate for bringing back Glass-Steagall’s separation of commercial banking and securities trading, also dismisses the merits of claims that the restriction would produce a competitive disadvantage. Hoenig sees that objection as somewhat like the argument--everyone else is doing it so why can’t I?

 

Like Black, Hoenig points out that prior to the end of Glass-Steagall, the U.S. banking industry was the strongest in the world and a leader. “We should get back to the position of strength,” he told Bloomberg Radio in an interview last June 26.

 

Role in financial crisis

 

Perhaps the strongest argument against bringing back Glass-Steagall is the one being made that the repeal of Glass-Steagall had little or nothing to do with the financial crisis of 2008.

 

“If you think about it, there was absolutely nothing in the financial crisis that was affected by allowing banks to be affiliated with firms that were engaged in underwriting and dealing in securities,” says Peter Wallison, co-director of the financial policy studies program at the American Enterprise Institute, Washington, D.C., and a commissioner on the Financial Crisis Inquiry Commission.

 

Wallison says the matter of what was or was not repealed also needs to be cleared up. Only one of two key provisions involving investment banking was repealed. Still in effect is section 16, which bars banks from engaging in underwriting and dealing in securities. Section 20, which bars banks from affiliating with firms that engage in underwriting and dealing with securities, has been repealed.

 

The real culprit in the financial crisis, Wallison says, was faulty mortgages and their related securities and derivatives. “Every firm that got into trouble in the financial crisis got into trouble for holding mortgages or mortgage-backed securities [MBS],” he points out. If Glass-Steagall had been left exactly as it was and not repealed, all the activities involving mortgage-backed securities and their derivatives, such as collateralized debt obligations (CDOs), would still have occurred, Wallison argues.

 

Further, the argument that deposit insurance subsidized risky behavior that caused the crisis also falls short, according to Mark Calabria, director of financial regulation at the Cato Institute, Washington, D.C. Most of the big companies that got into trouble--such Fannie Mae, Freddie Mac, Bear Stearns and Lehman Brothers--did not take deposits and, thus, deposits were not subsidizing their activities, Calabria says.

 

“Those companies that take deposits that got into trouble, such as Wachovia and Washington Mutual, got into trouble because of bad lending and not because of their Wall Street activities,” Calabria contends. “It is a misplaced perception that people were using deposits to gamble on Wall Street,” he concludes.

 

Thus, arguments that the repeal of Glass-Steagall helped bring about the financial crisis “are not in any way backed up by actual evidence,” maintains Calabria.

 

FDIC’s Hoenig takes exception to claims that there is no evidence of a link. He points out that depository commercial banks like Citigroup originated credit default swaps and CDOs, and gave lines of credit to people who sponsored them.

 

“Yes, they were part of the problem. They encouraged risk-taking by mixing banking activities with other activities,” he told Bloomberg Radio in the June 26 interview.

 

Further, Hoenig has argued in interviews, speeches and commentary that Bear Stearns was engaging in behavior similar to what banks do when they take deposits and lend out the money when they issue repurchase agreements (repos) to fund assets. The activity at Bear Stearns was part of the rise of the shadow banking system that caused the crisis, and came as a result of the repeal of Glass-Steagall, Hoenig has argued.

 

Calabria says he is somewhat sympathetic to concerns that financial institutions would use the safety net to engage in risky activities, and worries that this might lead to a government bailout. “I don’t want to bail out bad mortgages any more than I want to bail out Wall Street,” he says.

 

Even so, Calabria thinks that proponents of Glass-Steagall are being inconsistent about policies that distort markets. “They are saying in effect that some activities like mortgages are risky, but those are politically favored so we allow them access to the safety net; whereas other activities, such as underwriting corporate bonds, are apparently disfavored,” Calabria contends.

 

The argument that policymakers need to worry about Wall Street but ignore mortgage lending is an artificial distinction and should not be the basis for public policy governing banking and financial markets, according to Calabria. “We’ve all learned that ‘regular lending’ like mortgages can be pretty risky,” he says.

 

A lot of the concern revolves around speculation, he notes, but the financial crisis of 2008 illustrates that “making a mortgage is a speculative activity about whether you will get paid back or not.” Of course, mortgage lending is a debt secured by a hard asset that a lender has the right to claim and sell if a borrower defaults, which is not the case for unsecured speculative activities.

 

Citigroup

 

Those who favor bringing back Glass-Steagall often point to the extraordinary effort required to bail out Citigroup during the financial crisis as a prime example of why the law needs to be reinstated.

 

Citigroup--one of the nation’s largest depository institutions--jumped into the CDO business at the height of the housing bubble.

 

Calabria cites an infamous statement former Citigroup CEO Chuck Prince told The Financial Times in July 2007: “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Five months later, Prince was ousted as chief executive officer after the bank reported huge losses from its CDO business.

 

Calabria thinks that regulators should have either let Citigroup fail or should have broken it up rather than bail it out. “There’s something wrong at Citibank, and it isn’t Glass-Steagall,” he says, pointing to a prior bailout in the 1980s when the bank got into trouble lending to Latin America after those countries were unable to service their debt.

 

Some critics of Glass-Steagall go one step further and say the original law was itself not the right response to the crises of that day. That’s the conclusion of a 1993 study done by two University of Chicago professors of economics, Raghuram Rajan and Randall Kroszner. Rajan is currently governor of the Reserve Bank of India and Kroszner served as a governor of the Federal Reserve System from 2006 to 2009.

 

Rajan and Kroszner found that during the years leading up to the passage of Glass-Steagall, the securities firm affiliates of banks issued higher-quality securities issues than did independent securities firms not affiliated with a bank. Their study, published in the American Economic Review, is titled Is the Glass-Steagall Act Justified? A Study of the U.S. Experience in Universal Banking before 1933.

 

“Allowing commercial and investment banking to take place under one roof did not lead to widespread defrauding of investors,” Rajan and Kroszner wrote.

 

The better performance of securities affiliates of banks was most pronounced among the lower-rated issues, Rajan and Kroszner found. Their conclusion? “Our study indicates that the focus of legislative action on protecting the investing public from the effects of conflicts of interest has been misplaced.”

 

Abernathy argues that Gramm-Leach-Bliley created stronger and more diversified institutions that were better able to weather the financial crisis and even play a role in resolving it.

 

“A number of what you might call the Gramm-Leach-Bliley banks were buying up what I call the Glass-Steagall banks – the banks that could exist under the Glass-Steagall rules, which were the ones that were failing,” Abernathy says. Diversified depository banks like JPMorgan Chase and Bank of America were able to buy up investment banks such as Bear Stearns and Merrill Lynch. “The ones that were more diversified had the financial strength to be purchasing those failed banks,” Abernathy says.

 

Carter Glass

 

Glass-Steagall was championed by two Southern Democrats: Sen. Carter Glass (Virginia), a former secretary of the Treasury under President Woodrow Wilson from 1918 to 1920, and Rep. Henry Steagall (Alabama). The two legislators, with the political backing of President Franklin Delano Roosevelt (FDR), were able to overcome significant opposition in Congress to enact the law.

 

“Glass-Steagall had nothing to do with deposit insurance,” says Bove, who has studied the career of Carter Glass. Instead, he contends, the Virginia senator was concerned that banks were devoting too much of their resources to lending for speculating in securities and not enough to making loans to local businesses and farmers.

 

Glass had devoted part of his earlier career promoting more liquidity in the banking sector. For example, Bove points out, in 1913, when Carter Glass was chairman of the House Committee on Banking and Currency, he worked with President Wilson to pass the Owen-Glass Federal Reserve Act, which created the Federal Reserve System.

 

Donald Langevoort, professor of law at Georgetown University Law Center in Washington, agrees that Carter was worried about the lending practices of banks. He found it alarming, for example, that in 1930, 41 percent of all bank assets were invested in securities or securities-related loans.

 

“Glass was extremely troubled during the later 1920s by extensive bank lending to finance securities purchases--not because he was opposed to the stock market itself, but because he believed that such lending was taking money away from local businesses in need of credit,” Langevoort wrote in a February 1987 University of Michigan Law Review article titled “Statutory Obsolescence and the Judicial Process: The Revisionist Role of the Courts in Federal Banking Regulation.”

 

By barring banks from securities underwriting and dealing, Carter Glass sought to get the credit the economy so desperately needed flowing from the banks to farmers, businesses and consumers, according to Bove.

 

“Carter Glass understood that the core idea to resolving economic downturns is what [former Fed Chairman Ben] Bernanke is saying today. You’ve got to get money into the economy, you’ve got to get money where it is needed,” says Bove.

 

“Glass-Steagall is as much about that as anything else. There was no thought whatsoever anywhere along the line that deposit insurance would be funding risky investments. Nobody talked about that at all,” says Bove.

 

By the 1960s and 1970s, money was flowing into all sectors of the economy without the need for Glass-Steagall, according to Bove. “It got pushed aside simply by events in the economy,” he says.

 

Hoenig’s proposal

 

FDIC Vice Chairman Hoenig has probably done more to advance the idea of bringing back Glass-Steagall than anyone by being a frequent advocate for bringing back the separation of commercial and investment banking--and by developing a detailed proposal for a new  Glass-Steagall.

 

Not surprisingly, Hoenig sees the repeal of Glass-Steagall as a leading cause of the financial crisis. According to his view, after the Glass-Steagall repeal, banks began to bring more broker-dealer activities back into their operations and, under the safety net provided by the federal government, raising risk within those institutions.

 

“The markets assumed they would be protected, as they were. And that actually increased leverage in the industry, weakened the industry and eventually did lead to excess and the financial crisis of 2007 and 2008,” Hoenig said in his interview with Bloomberg Radio last June 26.

 

Hoenig put together his proposal to bring back the separation of commercial and investment banking in a 2011 white paper titled Restructuring the Banking System to Improve Safety and Soundness, which he co-authored with Charles S. Morris, vice president and economist at the Federal Reserve Bank of Kansas City. Hoenig is a former president of the Federal Reserve Bank of Kansas City.

 

FDIC deposit insurance and emergency lending by the Fed make solvent banks more stable by preventing runs in times of crisis, Hoenig stated in his white paper. The safety net, however, can lead to excessive risk-taking because it subsidizes banks, allowing them to borrow at lower interest rates. To address this risk, Hoenig proposed to restrict activities of banks by business line.

 

Hoenig’s proposal would allow commercial banks protected by deposit insurance to make loans and take deposits and provide payment, settlement, liquidity and credit services. They would also be able to engage in securities underwriting, advise clients on mergers and acquisitions, handle trusts and operate a wealth and asset management business.

 

Banks would not, however, be allowed to engage in broker-dealer activities under Hoenig’s proposal. Insured depository institutions could not make markets for securities or derivatives. Nor could they trade securities or derivatives for their own account or for customers.

 

The proposal, in effect, would remove a loophole in the Volcker Rule that allows insured financial institutions to engage in proprietary trading and in market making. They could not do that under Hoenig’s proposal. Hoenig would also bar federally insured banks from sponsoring hedge funds or private-equity funds.

 

There is a simple and direct guiding principle behind Hoenig’s proposal. “Banks should not conduct activities that create such complexity that their management, the market and regulators are unable to adequately assess, monitor and control bank risk-taking,” Hoenig wrote in his white paper.

 

The white paper acknowledged that trading and market making, omitted from his list of allowable business lines, are important to the economy. However, Hoenig stated that he does not think they should be subsidized by the safety net because that subsidy stimulates excess and in the process “imposes unnecessary risks and costs on the financial system and economy.”

 

Hoenig argues that taking commercial banks out of trading and market making in securities and derivatives will make these markets more competitive and less dominated by the largest investment banks now affiliated with commercial banks. It will, as a result, lower the barriers to entry and spur competition. “That will be good for the consumer. It will be good for business and for U.S. capital markets,” he told Bloomberg Radio.

 

Shadow banking

 

There is risk to pushing trading and market making outside the safety net, according to Hoenig. It might cause those activities to shift into the shadow banking system.

 

Such a shift would move trading and market making into financial companies that are not subject to prudential supervision and regulation and which rely heavily on short-term debt to fund longer-term assets and thereby increase systemic risk, according to Hoenig’s white paper.

 

The risky, if not rickety, structure of the shadow banking system led to the run on many financial institutions during the financial crisis as short-term funding dried up, according to Hoenig.

 

To mitigate risks in the shadow banking system, Hoenig offers two more recommendations. First, money market mutual funds would be required to have floating net asset values instead of the fixed $1 per share now required. The inability to maintain such a fixed value per share causes investors to flee when there is a fear that money market funds would break the buck, as occurred during the financial crisis.

 

The requirement that the fixed net asset value must be constant at $1 a share acts as a subsidy, according Hoenig, that leads to the overproduction of risky shadow banking activities. “[Floating net asset values in money market funds] would bring greater discipline to the market because [investors in such funds] would know they would not be bailed out in a crisis,” he wrote.

 

Hoenig also faulted a 2005 change in the bankruptcy law that allowed mortgage-related assets to be exempt from the automatic stay in bankruptcy when a borrower defaults on a repurchase agreement or repo. This, too, is a subsidy that encouraged excessive use of mortgage assets in short-term funding vehicles, according to Hoenig. It helped expand the size of shadow banking and made it more vulnerable to runs because it relied on mortgage assets that turned out to be riskier than anyone imagined.

 

How does the bankruptcy law subsidy work? “Because repo lenders can take immediate possession of the collateral and sell it to recover its market value if the borrower defaults, they are willing to lend to the borrowers at lower rates,” says an economist familiar with the white paper. “They are also willing to take smaller haircuts on such repo compared to other long-term debt and equity collateral,” he adds.

 

Before 2005, the automatic stay exemption for repo collateral applied to “commercial bank short-term liabilities or U.S. government and agency debt, which had minimal credit and duration risk,” the economist says.

 

If MBS were to lose their exemption from the automatic stay, there would be far lower volumes of repo funding backed by all sorts of collateral, including mortgage securities, according to the economist. For example, at Bear Stearns before 2005, only 19 percent of funding was done with repos. “Two years later, 76 percent of its funding was repo,” the economist says.

 

Hoenig acknowledges that restrictions he and Morris propose on money market funds and the use of mortgage-backed securities as collateral in short-term funding could drive up the cost of mortgages and other consumer loans. Even so, “it would be less risky and more reflective of the true costs,” he wrote.

 

Prins applauds Hoenig’s proposal. “It’s good the FDIC comes out to say we should mitigate the situation before there is a crisis,” Prins says.

 

Any real traction?

 

While the movement to bring back Glass-Steagall has shown it has some staying power, it lacks the necessary critical mass of supporters.

 

To be sure, the case for reinstating a separation between commercial and investment banking has strengthened somewhat, as people like former Citibank CEOs Reed and Weill take up the cause. However, for such an effort to ultimately succeed, it would require vigorous support from the banking industry, according to Prins. And that is very unlikely to happen.

 

Prins concludes, “The point is that spinoffs would require the investment banks to find extra capital and to hold more risk.”

 

She adds, “It doesn’t behoove them to do that in today’s world. They would prefer not to, which is why no leader who is actually running a bank today in the position of a CEO or chairman is saying that.”

 

Banks will lobby against a return to Glass-Steagall because they want to keep a strong banking system as an important part of the economy, according to Abernathy.

 

In the United States, banking makes up 25 percent of the financial services industry while in Europe it’s about 75 to 80 percent, Abernathy claims. “And a big part of that is that non-banks got into the banking business in a major way in the U.S,” he says. Insurance companies and securities firms offer deposit-like accounts with items that look like checks and they also make loans and offer a range of investments, Abernathy argues.

 

The United States is stronger because of its mix of financial services players, Abernathy recognizes. However, it is also important for the banking sector to remain a strong part of that mix, he adds.

 

“The banking industry has to remain competitive or it shrinks away,” Abernathy says.

 

MB

 

 

bio: Robert Stowe England is a freelance writer based in Milton, Delaware, and author of Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, published by Praeger and available at Amazon.com. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

 

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Robert Stowe England is an author and financial journalist who has specialized in writing about financial institutions, financial markets, retirement income issues, and the financial impact of population aging.

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