Karen Shaw Petrou’s memorandum to the Federal Financial Analytics Clients on the practical result of a Glass-Steagall revival.
TO: Federal Financial Analytics Clients
FROM: Karen Shaw Petrou
DATE: July 22, 2016
The Practical Result Of A Glass-Steagall Revival
Work with me – assume that Donald Trump and Elizabeth Warren are a marriage made in financial-reform heaven. Their nuptial gift: Glass-Steagall reinstatement in all its foregone glory. Leave aside whether or not this is a good or bad idea. Instead, let’s look analytically at the practical – not policy — result and see then whether Glass-Steagall is indeed the answer to a reformer’s prayers.
Yarra Square Partners returned 19.5% net in 2020, outperforming its benchmark, the S&P 500, which returned 18.4% throughout the year. According to a copy of the firm's fourth-quarter and full-year letter to investors, which ValueWalk has been able to review, 2020 was a year of two halves for the investment manager. Q1 2021 hedge fund Read More
In our analysis of Sen. Warren’s Glass-Steagall revival bill, we noted that the proposal essentially said that anything an insured depository has done since 1933 that wouldn’t have complied with the 1933 Act is again forbidden. How, you ask, could anyone have done something between 1933 and 1999 – the putative “repeal” date – barred by Glass-Steagall? I’ll tell you how since I helped to start the crumbling of the battlements between commercial and investment banking.
In the early 1980s, I worked for Bank of America. Bank of America wanted to expand its retail services to include securities brokerage. Charles Schwab, then a path-breaking discount brokerage, wanted to sell itself to BofA. Small problem: Glass-Steagall. How to make it go away? Persuade the Fed of the carefully-crafted arguments by astute counsel that discount brokerage wasn’t “dealing” and that thus it could be done. So the Fed then said, so it was, and henceforth BofA owned Schwab – or at least it did until Charles Schwab himself recognized that banks aren’t exactly the place for the fun at heart and bought his company back again.
The Schwab decision broke the back of Glass-Steagall, which then went through numerous now well-established rulings by the FRB, OCC, and state regulators allowing an increasingly wide array of underwriting and dealing by banks. What the 1999 Gramm-Leach-Bliley Act did was not to repeal Glass-Steagall, but rather to permit insured depositories to affiliate with full-service investment banks in the holding company structure. However, the lines between commercial and investment banking were blurred years before and got only somewhat more indistinct each year thereafter until the Volcker Rule in 2010 rescinded authority for certain types of proprietary trading and investments (most of which tread far harder on the longstanding barrier between banking and commerce than on those set by Glass-Steagall.
The Volcker Rule notwithstanding, banks and BHCs now do a lot that markets rely upon – municipal-bond underwriting, prime brokerage (the backbone of market infrastructure), and market-making (critical to liquidity) coming immediately to mind along with asset securitization that, for all its risks, is nonetheless vital to credit origination. As a result, wishing things were the way they were between 1933 and 1999 is wishing to go somewhere over the rainbow.
The fact is that customers don’t get securities services from banks because they love banks. They get them because pricing and convenience entice them and most of the services customers now demand have been part of banking for decades without even a whisper of undue risk. Disentangling these services from banks would thus prove as formidable an undertaking as taking the bolt out of Frankenstein’s head and expecting him to go back to wanting love and comfort. Banking as it is may not be pretty, but it is what it is and customers now rely on it. Most, if not all, of these services would be sorely missed.
Of course, one might say that parting would be sorrowful only for a short time since non-banks would come back into the picture. If there’s an economic need for a securities service and banks can’t do it anymore, it arguably goes to non-banks. If banks price better than non-banks and the business moves outside banks, then the price goes up even if it’s arguably better that the business be done by a non-bank outside banking’s presumed safety net. Policy be what it may – pricing is inescapable.
I doubt that customers would readily expect cost hikes and service inconveniences when forced to find new providers, but basic economics tell us that less supply due to barriers on banks means higher prices from remaining providers. This will have a range of effects across the financial system, up to and including higher cost of credit and/or less availability in sectors like municipal finance and mortgages.
Assume, for the moment, though, that price hikes are minimal because non-banks fill the entire void. Is this good policy?
An even more fundamental question than pricing is whether this is a good idea. Do we really know what makes securities services so risky that they cannot be conducted in close proximity to insured deposits? The 1933 Glass-Steagall Act’s rationale wasn’t based on fears that one activity is riskier than another – its premise is that investment and commercial banking under a single roof pose corrupted conflicts of interest that cry out for correction. Examples cited at the time included cases in which banks were said to have made loans that went bad and bailed themselves out by issuing corporate debt to gullible investors who then bought the farm, as it were. Equity underwriting was similarly seen as a conflict because banks could make bets with depositor’s money in ways all too readily repeated in the 2000s by Fannie Mae and Freddie Mac in their heads-I-win, tails-you-lose deal with the U.S. taxpayer.
But, would prying securities underwriting and dealing out of banks eliminate conflicts of interest? Of course not. The distinctions between lending, underwriting, and dealing are now wholly indistinct in our age of asset securitization, mutual funds, structured financial instruments, and market-making. The key in my view to constraining conflicts of interest is not to build firewalls between one or another activity deemed too nice to know the other, but rather to identify conflicts of interest within the asset intermediation chain as it is now constructed and root them out wherever they might grow. Banning banks from securities activities doesn’t solve for perfidy in financial markets – it makes it easier because more of it goes outside the purview of prudential regulators.
So, repeal the sort-of repeal of Glass-Steagall in Gramm-Leach-Bliley and go back to 1933. See how you like the shadows. As we noted in a recent paper, about a third of U.S. credit already comes from non-banks (some of them owned by the government and thus putting taxpayers also at risk). Look beyond credit origination to other critical financial services – repos – and the same picture emerges. Simple solutions like those being bandied about for big banks may rouse the populace, but they don’t make banking better or the financial system safer. That’s harder.