Obama’s Bank-Busting Regulation Full of Bugs

President Obama’s proposal on Thursday to bring back 1930s-era separation of commercial and investment banking would do little to prevent the problem of financial institutions being too big to fail.

What it would do is hurt economic recovery, reduce types of financing available to businesses big and small and give European and Asian financial services firms a huge competitive advantage over their U.S. counterparts.

It would leave U.S. banks, in the phrasing of American Enterprise Institute scholar and former Treasury Department official Peter Wallison, "too big to fail or succeed." The proposal puts forth nothing to stop bailouts or modernize bankruptcy laws to make failure less systemic.

Instead, the president’s proposal reintroduces a Depression-era structure for banking used nowhere else in the world. And it does nothing to stop the size or systemic dangers of the government-created financial giants Fannie Mae and Freddie Mac that were at the center of the mortgage crisis.

Glass-Steagall, named after the members of Congress that sponsored it, went into law in 1993. It was repealed in 1999 with the Gramm-Leach-Bliley law that passed Congress overwhelmingly and signed by President Clinton.

Then-Treasury Secretary (and now top Obama aide) Larry Summers told the Wall Street Journal in 1999 that the new law would spur economic growth "by promoting financial innovation, lower capital costs and greater international competitiveness."

This it did, while having little to do with the mortgage meltdown at the center of our economic woes, according to a variety of experts. Neither Bear Stearns nor Lehman Brothers were affiliated with commercial banks. Goldman Sachs and Morgan Stanley only became bank holding companies after they got into trouble.

As for the commercial banks that imploded — such as IndyMac, Wachovia and Washington Mutual — all went bust "by investing in bad mortgages or mortgage-backed securities, not because of the securities activities of an affiliated securities firm," noted Wallison, who is also a member of the Financial Crisis Inquiry Commission.

In fact, the crisis may have been much worse had Glass-Steagall still been in place. As Clinton pointed out in Business Week, the Glass-Steagall repeal "has helped stabilize the current situation" by allowing mergers of commercial and investment banks, such as that of Bank of America and Merrill Lynch, to go "much smoother than it would have been" when the law mandated a strict separation.

What’s needed? Update the bankruptcy laws for commercial banks, investment banks and combined operations, so that taxpayers are not holding the bag for any of them. Even before the bailouts, long-standing deposit insurance hazards were especially risky in allowing depositors to chase the highest interest rate without any inquiry into the safety and soundness of the bank.

Government entities and policies that encourage reckless lending, such as Fannie, Freddie, and the Community Reinvestment Act also need to be abolished or phased out.

Meanwhile healthy competition and innovation should be encouraged among all types of financial institutions to get credit to the entrepreneurs who will jump-start our economy.

Congress should raise limits on credit unions’ ability to engage in business lending. Community banks should be allowed to raise capital without going through the onerous accounting mandates of Sarbanes-Oxley, especially since they already go through stringent audits from bank examiners.

And the Federal Deposit Insurance Corporation should lift the moratorium preventing retailers such as Wal-Mart, Home Depot, and units of Berkshire Hathaway from forming their own limited banking operations.

In short, the biggest systemic risk is that of hazardous government subsidies to and regulation on the financial sector.