Want to Revive Glass-Steagall? Try This Wall of Separation Instead

A debate is raging on the left, the right, and even in libertarian circles on the best way to escape from the Too-Big-To-Fail quagmire. These days it seems that the only people claiming we don't have a banking problem are the ones counting their bonuses as they get ready to beat it out of town when the house of cards collapses. But despite widespread consensus of trouble ahead, efforts to define the problem often degenerate into a clash of competing narratives designed to advance partisan agendas. How can we expect to find solutions given this state of affairs?

Witness Dodd-Frank, a dysfunctional Rube Goldberg creation billed as the solution to keep meltdowns like the one of 2007/2008 from ever happening again. Instead, it unleashed a Pandora's Box of vague, incomplete, and undefined regulatory powers placed in the hands of unaccountable bureaucrats. Dodd-Frank's biggest impact has been to sow chaos across an industry that has responded by becoming even more concentrated.

Most of the proposed "solutions" coming out of Washington don't have a prayer of working because they don't address the real problem–the moral hazard created when profits are private but losses must be covered by taxpayers. But don't expect politicians to care. What could be better for both agitating voters and raising campaign funds than a scary unsolved problem that can be repeatedly flogged as America's economy stumbles from crisis to crisis?

Those of a more statist bent are seeking to re-impose the Glass-Steagall separation of commercial and investment banking. That might be worth considering if TBTF problems had arisen because investment bankers were putting demand deposits at risk in illiquid business ventures, thus leading to a run during a cyclical downturn. But that is not what happened during the 2007/2008 crisis–nor is it what is waiting for us when the Bernanke bubble bursts.

After the 2007 housing correction, commercial and investment banks could have absorbed mortgage bond losses without crashing the economy. This would–and should–have been painful for all those directly exposed, but would not have triggered widespread economic devastation had the so-called shadow banking system not seized up.

But when Lehman Brothers collapsed, all hell broke loose, as the repo and commercial paper markets froze and the margin call cascade revealed the inadequacy of counterparty collateral arrangements. This impacted a widening circle of investors, savers, and companies that had no connection whatsoever to the housing market. Washington responded with a bipartisan, indiscriminate, and panicked bailout.

So, can anything be done? There are two schools of thought on how to reform the shadow banking business, where excessive leverage is considered a feature, not a bug.

The first argues for forcing everyone that deals in any kind of financial product to comply not only with existing bank regulations, but with thousands of new rules yet to be designed to manage the risks associated with the growing array of exotic financial instruments devised and traded by shadow banks.

This regulate-everything approach has about as much chance of preventing another meltdown as deputizing Bozo the Clown to police Gordon Gekko. But for politicians, it has the attractive feature of vastly increasing their power and campaign fundraising prowess. It will also expand revolving door opportunities between Wall Street and the Fed, Treasury Department, SEC, CFPB, and an expanding alphabet soup of agencies created to regulate every novel way of buying and selling risk.

The second approach argues for drawing a clear no-bailout line in the sand–and building a wall atop it.

Banks on one side of the wall would get today's full array of regulations and subsidies, including FDIC deposit insurance, federal mortgage guarantees, exchange transparency, capital requirements, stress tests, access to the Fed as a lender of last resort, cheaper cost of capital due to the presumption of bailout, Community Redevelopment Act obligations, and consumer protections du jour.

Banks on the other side, along with their customers, would need to comply only with the broader commercial, bankruptcy, and anti-fraud statutes under which every business operates. Most importantly, they would operate in a caveat emptor banking environment, being legislatively prohibited from receiving any form of government subsidy, insurance, rescue, or bailout.

Which businesses go inside and which go outside? Let each bank decide. But they have to pick one–no co-mingling of balance sheets, customer accounts, management teams, boards of directors, or financial products. Bankers and customers would have a clear choice of regulated or unregulated worlds in which to operate.

Nothing would prevent individuals from owning shares in both regulated and unregulated financial firms. But any counterparty that trades with a regulated bank has to follow all the rules. And any counterparty that does business with an unregulated bank has to accept all the risks.

Making regulation a matter of choice and consequences has several virtues. First, it obviates the need to define the difference between a commercial bank, an investment bank, and a shadow bank–a fool's errand if there ever was one. Second, it acknowledges the inconvenient fact that U.S. regulators do not have global jurisdiction. Third, it will reduce concentration by encouraging the big banks to divest businesses along lines of their own choosing without the inherent corruption and unintended consequences of bureaucratic edicts. Best of all, it creates a living laboratory to assess the efficacy of regulations when it comes to serving consumers' needs and solving banking problems.

How do we actually implement this thought experiment? How do we bind, not just financial institutions, but future Congresses from bailing out the risk takers? That's the $64,000 question. But once we figure out the answer, let's not settle for halfway measures like Glass-Steagall. Let's build a wall as high as it can go.