A ’21st Century Glass-Steagall’ Would Be Bad for the Financial System

This post is the third in a 3-part series on banking regulation and the Glass-Steagall Act. The first two parts are “Lawmakers Should Shun Long-Repealed Bank Restrictions,” and “Glass-Steagall Would Not Have Prevented the Financial Crisis.”

Director of the National Economic Council Gary Cohn (a former Goldman Sachs executive) told Bloomberg TV on Friday that “If we come up with a 21st Century, modern Glass-Steagall, we may be able to tailor regulation for different aspects of the financial markets and different aspects of the financial institutions.” Capital Alpha’s Ian Katz noted the similarities to the UK’s rules that were introduced after the 2011 Vickers Report, saying “there’s been a lot of talk in Washington about the possibility of a U.K.-style ring-fencing plan in which higher-risk activities are cordoned off, though the same bank can conduct both commercial and investment banking.”

This would be a bad idea. Expert commentators in the UK have noted several problems with the Vickers system. Washington policy-makers should take heed of these warnings and avoid making the same mistake.

Ring-fencing, as Katz explained, refers in this case to the legal separation of retail banking divisions from global trading, investment banking, and brokerage services, so that they are operated as a separate entity.  ‘Inside’ the ring-fence must fall all retail deposits and their overdrafts, while investment banking activities including derivatives, debt and equity underwriting, and investing and trading in securities must fall ‘outside’. Banks are free to place consumer and business lending as well as trade finance on either side of the fence.

While the rule is intended to “protect taxpayers from ever having to bail out a bank again”, there is little reason to believe that the ‘Vickers Rule’ will do just that. Limiting competition and attempting to mitigate bank failures simply reinforce the possibility of ‘Too-Big-To-Fail’ rather than lessen it. As Mark Littlewood of the Institute of Economic Affairs has pointed out, the focus has been on entrenching large banks so that they never fail, rather than making sure that banks—like any other business—can fail properly without disrupting the wider economy and leaving taxpayers to foot the bill. Ring-fencing focuses on all the wrong things.

Just like Glass-Steagall, ring-fencing would have had little-to-no effect on the unfolding of the financial crisis. Littlewood notes that, “The idea that bank ring-fencing will safeguard banks from failure is a fiction. Lehman Brothers was an investment bank without a retail arm, Northern Rock was a retail bank without an investment arm; ring-fencing would have had no effect on either.” The risk posed to the financial system during the 2007 crisis was from banks that would have complied with ring-fencing requirements. Artificial separation will not make either of the sectors safer, but is rather, as St. Mary’s University economics professor Philip Booth says, an elegant solution looking for a problem.

In an era of growing populism and anger towards Wall Street, it has also become fashionable on both sides of the pond to label commercial banking as essentially safe, while characterizing investment banking as inherently risky. But these claims simply do not hold water. All forms of banking involve risk, including mortgages and small business lines of credit. As noted above, Northern Rock, one of the greatest busts in the UK crisis, was a retail bank. On the other hand, banks that mix retail and investment arms may be better able to diversify risk. For example, retail losses resulting from a collapsing property market can be balanced by gains in other asset classes. As I have written elsewhere, to re-impose a firewall between commercial and investment banking now would be to inject risk into the financial system, not reduce it.

As the UK’s Adam Smith Institute concluded, the Vickers Report was a missed opportunity. The report piled on “new levels of regulation when the problem was that former regulations were either poorly conceived, imperfectly enforced or went unheeded.” Rather than tackling the root cause of the crisis—moral hazard—regulators have pursued counterproductive measures. Instead of looking towards new ways to regulate banks, we should focus on increasing competition, transparency, and resolution regimes. As my colleague John Berlau writes, if we are to end “Too-Big-To-Fail” and foster an efficient and stable financial system, we must bring to the financial sector what virtually every other field of American business possesses: competition.