A strange-bedfellows mix of Democrats and Republicans have called for resurrecting the Glass-Steagall Act, a Depression-era law that separated commercial and investment banking.
For most of the 20th Century the law held back Main Street banks and shielded the big Wall Street banks from those smaller competitors. Why would anyone want that old problem back again?
Democrats have blamed the law’s 1999 repeal for causing the 2007-2008 financial crisis, while some Republicans have latched onto the old government mandate as a way to protect Main Street banks and consumers from Wall Street abuses. Both of these notions are dead wrong.
The financial crisis was not caused by allowing commercial and investment banks to be owned by the same parent corporation. The institutions that failed were either predominantly commercial or investment banks, but not both.
The commercial banks that failed, such as Wachovia, Washington Mutual and IndyMac, did so because they invested in subprime mortgages. The investment banks that got into trouble, such as Bear Stearns or Lehman Brothers, had no commercial bank affiliations.
The excessive risk-taking that lead to bank losses occurred in mortgage lending and securitization (the repackaging of pooled assets into securities), completely legal practices that would have occurred even under a Glass-Steagall regime.
In fact, separating banking activities would have increased the severity of the crisis. Investment banks that found themselves in liquidity crunches, such as Merrill Lynch, were able to be acquired by larger deposit-taking institutions, namely Bank of America, rather than go bankrupt.
Further, when Goldman Sachs (GS) and Morgan Stanley (MS) were under stress to acquire short-term funding, they were allowed to quickly reorganize into financial holding companies with commercial banking arms. The ability of these institutions to diversify their activities sheltered the financial system from further losses.
The most-integrated banks, those with both commercial- and investment-banking arms, were the strongest during the crisis. This remains the case today. The most recent Federal Reserve stress tests show that the banks that engage in unified banking, such as JPMorgan Chase (JPM), are in fact the healthiest.
On the other hand, Goldman Sachs and Morgan Stanley, two banks that concentrate primarily on investment banking, came the closest to failing on key measurements. Simply separating bank activities does not make the financial system any safer, nor would have it prevented the 2007-08 crisis.
The second mistake of Glass-Steagall proponents is their claim that they are “taking on Wall Street.” In reality, piling on complex regulations only serves to enrich well-connected big banks at the expense of smaller ones. Glass-Steagall systematically destroyed Main Street investment banking over its 66-year reign.
Prior to the government-imposed firewall, many commercial banks in cities throughout the country were active in securities underwriting and distribution.
For example, the Trust Company of Georgia, predecessor of SunTrust Banks (STI), organized a stock offering of Coca-Cola (KO) in 1919. Local residents of Atlanta, who celebrated not having to sell out to “New York interests,” subsequently bought nearly half of Coca-Cola’s stock.
That would not be possible under Glass-Steagall. The firewall forbade local commercial banks from venturing into investment banking, relegating the latter to specialized firms in New York.
Bringing back a failed government policy would only redistribute assets and activities among the existing big banks. The 10 largest banks would all remain designated as “too-big-to-fail” under a new Glass-Steagall, with the pure investment banks such as Goldman Sachs growing to become more systemically important, as American Enterprise Institute scholar Paul Kupiec has found.
It is little wonder then why Gary Cohn, the director of President Trump’s National Economic Council and former Goldman Sachs executive, is in favor of the measure.
The real solution to today’s financial woes is opening up the financial services sector to greater competition. House Republicans have been moving in the right direction by passing the Financial Choice Act this year, which would allow Main Street banks to grow their communities while removing Wall Street’s protections.
If the Senate does its part to pass the bill and send it to the President to sign, that is a policy that will foster an efficient and stable financial system that all Americans can rely upon.
Originally published on Investor’s Business Daily.