Results for “glass steagall”
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Glass Steagall: The Real History

Many wise people are now recognizing that the repeal of Glass-Steagall was one of the few saving graces of the current crisis.  Let’s thank President Clinton (and Phil Gramm) for that wise bit of deregulation.  The following potted history of the law, however, is all too typical:

Glass-Steagall was one of the many necessary measures taken by Franklin Delano Roosevelt and the Democratic Congress to deal with the Great Depression. Crudely speaking, in the 1920s commercial banks (the types that took deposits, made construction loans, etc.) recklessly plunged into the bull market, making margin loans, underwriting new issues and investment pools, and trading stocks. When the bubble popped in 1929, exposure to Wall Street helped drag down the commercial banks….The policy response was to erect a wall between investment banking and commercial banking.

Given a history like this people wonder how repealing the law could have been a good thing.  But a significant academic literature has investigated these claims and rejected them.  Eugene White, for example, found that national banks with security affiliates were much less likely to fail than banks without affiliates.  Randall Kroszner (now at the Fed.) and Raghuram Rajan found that (jstor) securities issued by unified banks were (ex-post) of higher quality that those issued by investment banks.  A powerful book by George Benston went through the entire Pecora hearings which supposedly revealed the problems with unified banking and found them to be a complete sham.  My colleague, Carlos Ramirez later showed that the separation of commercial and investment banking increased the cost of external finance (jstor).  Finally, my own work (pdf) unearthed the real reasons for the separation in a titanic battle between the Morgans and Rockefellers.

Thus, the history of banking before Glass-Steagall and now our recent experience after is consistent, generally speaking unified banking is safer and repeal was a good idea.

The Return of Glass-Steagall???

The Atlantic writes:

Hillary Clinton and Donald Trump, have included plans to reintroduce the [Glass-Steagall] bill in their economic platforms. The argument for the act is that it could have prevented (or at least dampened) the 2008 financial crisis, and that reinstating it could ward off future ones. Is that the case?

The Atlantic’s editors reached out to economists and experts in financial regulation to ask them why Glass-Steagall is seeing renewed popularity right now, and what they think would make America’s financial system safer in the future.

Here’s part of what I had to say:

When Black Lives Matter calls for a restoration of the Glass-Steagall Act we know that the Act has exited the realm of policy and entered that of mythology. No, restoring the Glass-Steagall Act would not end racism. Nor would restoring Glass-Steagall have done much, if anything, to have avoided the 2008-2009 financial crisis. Secretary of the Treasury Timothy Geithner was correct when he said the problems at the heart of the financial crisis had “nothing to do with Glass-Steagall.”

The financial crisis is best understood as a run on the shadow banking system, that collection of financial intermediaries who based their credit creation not on deposits but on repo, money market funds, structured investment vehicles, asset-backed securitizations and other financial structures. Separate commercial and investment banking? Please. The problem was that by 2007 the shadow banking system had become so separated from commercial banking that the Federal Reserve didn’t know that a majority of credit was being generated by the shadow banks.

…“Nothing has been done!” may play well in some quarters but the Obama administration has in fact imposed systematic reform on the financial system. Most importantly, capital requirements have been increased (leverage has been reduced), forcing financial intermediaries to have greater skin in the game and to provide a cushion in the event of a fall in asset prices. Moreover, capital requirements have been extended far into the shadow banking system. Most recently, the Fed has imposed a capital surcharge on the biggest institutions i.e. the too big to fail institutions.

…Ironically, despite the political power of the financial sector it seems that more has been done to raise bank capital ratios than to require homeowners to raise their capital ratios by requiring larger down payments. There is a lesson there.

Robert Reich, Sheila Bair, Lawrence White, Stephen G. Cecchetti and others also comment. Only Reich, with some support from Blair, is enthusiastic.

The Puzzling Return of Glass-Steagall

I am puzzled by the renewed demand for the return of Glass-Steagall. I am puzzled not because Glass-Steagall might be bad policy but because it is so clearly a policy that doesn’t deal with the problems that created the financial crisis. If one had to sum the crisis up in one sentence it would be hard to do better than “a run on the shadow banking system.” The shadow banking system is that collection of mostly non-bank financial intermediaries who base their credit creation not on deposits but on repo, money market funds, SIVs, asset backed securitizations and other financial structures. The big new fact that I learned from the financial crisis and that I thought someone like Elizabeth Warren would surely also have learned is that the shadow banking system is larger than the regular banking system.

Separate commercial and investment banking? Please. The problem was that investment banking, in the form of shadow banking, become so separated from commercial banking that the Fed no longer had any idea where a majority of credit was being generated. Credit creation separated from banking as understood by the Fed, and moved into the shadows, hence, the term shadow banking.

Compare Glass-Steagall with the Gorton-Metrick proposal to reform banking. GM would in essence extend deposit insurance to the shadow bank system, i.e. instead of separating commercial and investment banking, Gorton and Metrick would erase the distinction entirely by making all credit creators regulated commercial banks. (I exaggerate, but only slightly). If you don’t like that idea then consider Larry Kotlikoff’s limited purpose banking. Kotlikoff, in essence, goes the full Rothbard–separate lending from money warehousing (i.e. transaction-cost reducing money services) (Tyler offers some criticisms here).

Now whether you think the Gorton-Metrick or Kotlikoff proposals are good ideas, and I am not arguing for either, these ideas at least addresses the important issues. In contrast, Glass-Steagall would merely shuffle around organizational boxes in the less important regulated banking sector. Indeed, why would anyone think that 1930s policy is the solution to a 21st century problem?

Addendum: Here are previous MR posts on Glass-Steagall. FYI, my paper on the public choice aspects of Glass-Steagall showed that the public reasons for the original Glass-Steagall were not the private reasons. Is something like this going on today?

Luigi Zingales defends Glass-Steagall

Last but not least, Glass-Steagall helped restrain the political power of banks. Under the old regime, commercial banks, investment banks and insurance companies had different agendas, so their lobbying efforts tended to offset one another. But after the restrictions ended, the interests of all the major players were aligned. This gave the industry disproportionate power in shaping the political agenda. This excessive power has damaged not only the economy but the financial sector itself. One way to combat this excessive power, if only partially, is to bring Glass-Steagall back.

There is much more at the link (“Why I was won over by Glass-Steagall”), interesting throughout.  An ungated version is here.

The Glass-Steagall Act: A History of Thought

Me in 1985: The Glass-Steagall Act should be repealed.

Me in 1989: I’m not so sure about repealing the Glass-Steagall Act.  Repeal would, in effect, extend the protection of deposit insurance to investment banks and other risky entities.  Moral hazard is a real problem.

Me in 1996: It doesn’t seem to matter that much that they haven’t repealed Glass-Steagall.  The Fed is relaxing restrictions on banks in any case.

Me in 1999: What?  Did they repeal Glass-Steagall?  I wasn’t paying attention.

Me in September 13, 2008: Whew!  I’m sure glad they repealed the Glass-Steagall Act.  My 1989 worries were not crazy but I did not see that counterparty risk would spread the safety net to risky entities in any case, with or without explicit merger.

Me next week: How are we going to stop all these consolidated financial entities from taking advantage of deposit insurance and other public sector guarantees?

Raising Rival’s Costs and Reform in the Public Interest

How can we achieve reform in the public interest when the public is rationally ignorant and unorganized while the special interests are informed, organized and well funded?  Matt Yglesias draws some interesting lessons and hope (!) from my paper on The Separation of Commerical and Investment Banking: The Morgans vs. the Rockefellers (pdf).

Yglesias offers a brief summary of the paper:

The basic story is that the Depression led to a lot of public outrage about the financial system and the outrage was—as outrage tends to be—a little bit inchoate and not really focused on the fine-grained details of public policy. Meanwhile, the Rockefeller family and the Morgan family had some longstanding business conflicts between their respective empires. And the Glass-Steagall bill was essentially an effort by the Rockefellers to channel that inchoate public outrage in a direction that would harm the Morgans:

More than anyone else, Winthrop Aldrich, representative of the Rockefeller banking interests, was responsible for the separation of commercial and investment banking. With the help of other well-connected anti-Morgan bankers like W. Averell Harriman, Aldrich drove the separation of commercial and investment banking through Congress. Although separation raised the costs of banking to the Rockefeller group, separation hurt the House of Morgan disproportionately and gave the Rockefeller group a decisive advantage in their battle with the Morgans.

He then draws an interesting conclusion:

Tabarrok notes that when this kind of regulatory strategy is pursued in a given industry “the industry as a whole will shrink” even while one firm gains an advantage over its rivals. And here we have actually an answer to a question that’s troubled me for years: How, given political realities, can the financial sector ever be brought to heel?… It shows a way that smart and savvy would-be regulators can find ways to undermine sector-level political solidarity. Not just in ways that favor one firm against another (which would be pointless) but even in ways that shrink the sector as a whole.

Here’s the big picture. Under certain conditions, free markets channel self-interest towards the social good – that is the meaning of the invisible hand theorem. Unfortunately, there is no invisible hand theorem for politics. There are institutions, such as democracy, checks and balances and an independent judiciary, which help to channel political self-interest if not to the public good then at least away from the public evil. Even given the right macro institutions, however, breaking the iron triangle of politics is difficult. Industry self-interest and the public interest will typically align only accidentally. Universities are not less self-interested than any other actors but support for basic research is (arguably) in the public interest. The usual situation, however, is that industry self-interest pushes well beyond the point of alignment with the public interest. At current spending levels, lobbying by defense firms does not benefit the public even if national defense is a public good.

Yglesias is interested in the most difficult case when the public interest favors not a larger but a smaller industry. Will industry self-interest every align with a smaller industry? Rarely but if public anger against an industry is high then some industry participants may see that a smaller industry is consistent with their self-interest if their share of the industry grows enough as the industry shrinks–a bigger share of a smaller pie. This is the theory of raising rival’s costs that I argue led to the Glass-Steagall Act. Other examples of raising rival’s costs are firms like Costco, that already pay high wages advocating for increases in the minimum wage.

Could we apply this strategy to the provision of other public goods? Here’s an idea. The best political strategy to combat global climate change may be to bring the cleaner parts of the energy industry into a coalition with environmentalists to support a carbon tax. That means bringing the environmentalists together with the nuclear, hydro-electric and fracking part of the energy industry in a play to raise the relative costs of coal and foreign oil. Could this happen? It is unlikely but not inconceivable. As Yglesias says it would take “a smart and savvy” regulator and, I would add, a public-interested regulator (a small but let’s be charitable and say not a zero intersection) to bring the coalition together. You can see why I am less optimistic than Yglesias that the theory can be used to support the public interest but no one said that smart, savvy, public interested regulators would have it easy.

Ice cream shadow banking markets in everything

State banking officials want to put the freeze on the owner of an ice-cream parlor who opened a community-bank alternative that pays interest in the form of gift cards for ice cream, waffles and coffee.

Ethan Clay, 31 years old, opened Whalebone Café Bank seven months ago in his shop, Oh Yeah!, a year and a half after he was hit with $1,600 in overdraft fees from a local bank where his account was overdrawn by a series of checks.

Mr. Clay says he wants to offer an alternative banking experience, and has accepted small deposits and made small loans. He claims he isn’t subject to banking rules because his operation is a gift-card savings account.

“It’s a strange case, we don’t have the authority to go close an ice-cream store,” said Ed Novak, spokesman for the Pennsylvania Department of Banking. “But we are going to do something. You can’t mess with people’s money.”

The article is here, here is Philip Wallach’s new paper (pdf) on whether we need a new Glass-Steagall.

Has India solved the problem of banking regulation?

Forget Glass-Steagall:

The branches are run almost entirely by and for the children, with account holders electing two volunteer managers from the group every six months.

“Children who make money by begging or selling drugs are not allowed to open an account. This bank is only for children who believe in hard work,” said Karan, a 14-year-old “manager”.

During the day, Karan earns a pittance washing up at wedding banquets or other events. In the evening, he sits at his desk to collect money from his friends, update their pass books and close the bank.

“Some account holders want to withdraw their money. I ask them why and give it to them if other children approve. Everyone earns five per cent interest on their savings.”

This system now has over two hundred branches in half a dozen countries.  The article is here, hat tip goes to Kottke.  If I understand the account correctly, it is also run largely by street children.

*Inside Job*

Nick writes to me:

I'm an undergrad math/Econ double major and aspiring economist. I also read your blog (amongst others) daily. You said today that "Inside Job" was "half very good and half terrible." Critical reviews are widespread, but prominent economists haven't said much. I was wondering if you could expound on your terse critique in an email or blog post.

It's been a while since I've seen the movie, but here goes.  The best parts are on excess leverage, the political economy of the crisis, and the attitudes of the economics profession.  Overall it is remarkable how much economics is in the movie, even though some of it is quite bad.  The visuals and pacing are excellent and many scenes deserve kudos. 

The worst parts are the misunderstandings of deregulation.  Glass-Steagall repeal was not a major factor, much of the sector remained highly regulated, and there is no mention of the failure to oversee the shadow banking system.  The entire discussion has more misses than hits.  The smirky association of major bankers with expensive NYC prostitutes (on one hand based on very little evidence, on the other hand probably true) was inexcusable.  There is talk of "predatory lending," but it is not mentioned that many borrowers committed felonies, or were complicit in felonies ("on the form, put down any income you would like").  Most generally, there is virtually no understanding of the complexity of the dilemmas involving in either public service or in running a major corporation.

Overall, the movie's smug moralizing makes me wonder: is this a condescending posture, spooned out with contempt to an audience regarded, one way or another, as inferior and undeserving of better?  Or are the moviemakers actually so juvenile and/or so ignorant of the Western tradition — from Thucydides to Montaigne to Pascal to Shakespeare to Ibsen to FILL IN THE BLANK — that they themselves accept the very same simplistic moral portrait?  If so, most of all I feel sorry for how much of life's complexities they are missing and how impoverished their reading and moviegoing and theatregoing must be. 

Do you remember the scene in Hamlet, where Hamlet tries to judge the King by enacting a pantomime play in front of him, to see how the King would respond to a work of art?  I think of that often.

*Too Big to Save*, by Robert Pozen

For the last two years I've been receiving requests — email and otherwise — for a readable, educating book on the financial crisis.  And while various books on the crisis have had their merits, no one of them has fit that bill.  Until now.

Robert Pozen's Too Big to Save: How to Fix the U.S. Financial System is the single best source for figuring out what happened.  It is the go-to book if you are a non-specialist and want to understand: how credit default swaps work, the significance of Basel II, mark-to-market, how the various Fed bailouts operated, the meaning of the toxic asset plans, and many other matters.

This is not so much a presentation of a macro narrative on the crisis as an education manual on the moving parts.  Its value stands above and beyond any particular partisan view.  Pozen, by the way, offers policy recommendations at the rough rate of about one a page and most of them are quite micro.  Even if I do not agree with everything he says, his proposals are unfailingly reasonable and well-argued and grounded in fact in some manner.

You can pre-order the book here

Here is my previous post on the book.

By the way, Pozen does refer to blogs and he even cites blog posts.

My views on the crisis — a summary statement

A few inattentive malcontents are complaining that I haven’t stated my views.  I have, but if you want them, or some of them, in one neat place, devoid of subtlety or explanation, here they are:

1. Glass-Steagall repeal was not a major cause of the financial crisis, nor was government-induced "minority lending."

2. We should use regulation to move more of the currently unregulated derivatives markets to the clearinghouse model.

3. The crisis represents a massive conjunction of both market and governmental failure.

4. I would not nationalize banks as ongoing concerns, at least not short of a far more extreme emergency than the current status quo.

5. The modified Paulson plan was better than nothing — especially after the market had been scared — but far from my first choice.  In any case the plan would have been revised almost immediately.  The Paulson and Dodd plans were never that far apart.

6. My first choice is to induce and if need be to force more information revelation, identify the insolvent banks, close them up, and give the battle-tested FDIC a much greater role in the whole process.

7. In the meantime the Fed should not worry much about inflation.

8. The critical deregulatory mistake was allowing excess leverage.  Many deregulations get blamed but in fact contributed little to the problem.

9. Everyone says that letting Lehman die was a big mistake but I’m not yet convinced.  Maybe a bracingly high TED spread is what we need.

10. Libertarians are overrating the moral hazard argument, as many equity holders have been wiped out.

11. If someone is pushing conclusions and not identifying the potential weak points in his or her arguments, be suspicious.  Also beware of anyone pretending to offer you simple answers.

12. I have a long and complicated view on the relevance of Austrian Business Cycle Theory which resists easy summation, but markets could have and should have been more cautious in response to Greenspan’s easy money policies.

13. Insolvent hedge funds and the commercial paper market remain outstanding issues which are not easy to address.

14. I agree with Arnold Kling about relaxing capital requirements though at this point I don’t expect it to help much.

15. The crisis is complex and has many causes; there won’t be a simple or quick solution.

If you wish you can google to the details.  Also, I don’t believe I had offered #9 before on this blog.

Did the Gramm-Leach-Bliley Act cause the housing bubble?

No.  That is one common myth among the progressive left.  Because it involves financial deregulation and the unpopular Phil Gramm, the Act is vilified and assumed to be part of a broader chain of evil events.  Here are some of the articles which promulgate the myth that the Act caused or helped cause the housing bubble.  One version of the claim originates with Robert Kuttner, but if you read his article (and the others) you’ll see there’s not much to the charge.  Kuttner doesn’t do more than paint the Act as part of the general trend of allowing financial conflicts of interest. 

Most of all, the Act enabled financial diversification and thus it paved the way for a number of mergers.  Citigroup became what it is today, for instance, because of the Act.  Add Shearson and Primerica to the list.  So far in the crisis times the diversification has done considerably more good than harm.  Most importantly, GLB made it possible for JP Morgan to buy Bear Stearns
and for Bank of America to buy Merrill Lynch.  It’s why Wachovia can consider a bid for Morgan Stanley.  Wince all you want, but the reality is that we all owe a big thanks to Phil Gramm and others for pushing this legislation.  Brad DeLong recognizes this and hail to him.  Megan McArdle also exonerates the repeal of Glass-Steagall

Here is a good critique of GLB, on the grounds that it may extend "too big to fail" to too many institutions.  That may yet happen but not so far.   

The Act had other provisions concerning financial privacy.

Maybe you can blame some conflict of interest problems at Citigroup and Smith Barney on the Act.  But again that’s not the mortgage crisis or the housing bubble and furthermore those problems have been minor in scale.  Ex-worker has a very sensible comment.  The most irresponsible financial firms were not, in general, owned by commercial banks.  Here’s lots of informed detail on GLB and the bank failure process.  Here is another good article on how GLB didn’t actually change Glass-Steagall that much.

Here’s a Paul Krugman post on GLB; he attacks Phil Gramm but he doesn’t explain the mechanism by which GLB did so much harm.  The linked article has no punch on this score either, although you will learn that Barack Obama has scapegoated GLB, again without a good story much less a true story. 

I may soon cover the Commodity Futures Modernization Act as well.

Should we regulate banks more?

In the wake of subprime losses we are hearing claims that the United States should have regulated its banks more.  It is worth pointing out that the U.S. has some of the most heavily regulated banks in the world:

1. The Bank Holding Company Act of 1940, still in force, prevents bank from owning non-financial corporations.

2. The previous Glass-Steagall Act (repealed in 1999) discouraged banks from diversifying out of home mortgages.

3. The Office of the Comptroller of the Currency charters, regulates, and oversees banks, including with respect to risk.

4. Several rounds of the Basel accords, including subsequent fine-tunings, have regulated bank capital holdings and reporting requirements.  These are international regulations and not the sole design of a possibly defective U.S. regulatory system.

5. Banks are chartered by individual states and subject to varying regulations, disclosure, and reporting requirements, including with respect to risk.

6. Banks are regulated and supervised by the Fed, especially with regard to their risk-taking.

7. Banks are regulated and supervised by the FDIC, especially with regard to their risk.

8. Banks face additional regulations, both at the state and federal level, to the extent they are involved in commodities and insurance markets.

9. The Federal Housing Finance Board regulates Federal Home Loan Banks, which are involved in mortgage markets.

10. The Sarbanes-Oxley Act applies to publicly traded banks.

11. The Gramm-Leach-Bliley Act, the revision of the Glass-Steagall Act, regulates bank assets, albeit less than in times past. 

12. The Home Mortgage Disclosure Act "…requires financial institutions to maintain and annually
disclose data about home purchases, home purchase pre-approvals, home
improvement, and refinance applications involving 1 to 4 unit and
multifamily dwellings."  These regulations are intended to limit the ability of banks to discriminate against borrowers; in practice this encourages subprime loans.

13. The Community Reinvestment Act encourages banks "to reinvest in the communities they serve," which again in practice encourages subprime loans.

14. I believe this list is not complete.

I guess we didn’t have enough bank regulation!

It is also worth noting that many European banks have suffered heavy losses as well, despite operating under different regulatory regimes.

It is plausible to argue that the United States should have fewer bank regulators (I’ll nominate the Fed for the main role), but that consolidation should be accompanied by greater efficacy of regulation.  In the meantime there are too many regulatory authorities, and too many regulations.  We have completely blurred lines of accountability, legal, political, economic, and otherwise.

The new Stiglitz book

Last night I read my newly-arrived copy of Joseph Stiglitz’s The Roaring Nineties: A New History of the World’s Most Prosperous Decade. As you might expect from Stiglitz, it is well-written and smart.

His key theme is that, although the nineties were a wonderful time economically, they also brought some dangerous trends. Most of all, the capital market ruled resource allocation, and economic policy, like never before. We misallocated resources on a tremendous scale, such as with the telecommunications boom and bust. Stiglitz also argues against the deregulation of the nineties, as too little was done to reign in corporate abuses, such as Enron. He also believes that the Clinton administration was too obsessed with balancing the budget.

My hesitations about this book are simple: We are never given much of a recipe for how things could have been better. Stiglitz opposes the repeal of Glass-Steagall, and the Clinton telecommunications reforms. To be sure, these policies were problematic in some regards, but they did not drive the excesses of the 90s. To what extent can government policy limit a or fiber optic boom? To what extent can government policy, as opposed to intra-firm institutional reforms, limit corporate conflicts of interest? We do not get much of an inkling on these critical issues.

Occasionally Stiglitz gets specific, but his examples do not help his case: “Would the bubble have been averted if only we had only supported better accounting of executive stock options? We will never know the answer.” But the answer is almost certainly “no,” most commentators regard the option accounting issue as a red herring, here is one treatment of many.

It is OK to write a pure critique, rather than a recipe for change, but the book promises “a coherent and convincing alternative.” That is precisely what we do not get. The final chapter “Toward a New Democratic Idealism” also does not move beyond the vague. It is not enough to say we had too much deregulation and forgot our concern with social justice.

Stiglitz also expresses concern that the Clinton administration pushed “market fundamentalism” on the poorer countries of the world, while rejecting it at home. I cannot agree here. Even if you take the Stiglitzian worldview as correct and given, the quality of government in the developed countries is much higher than in the developing world. Admittedly the quality of the market is often higher as well, but why promote a regulatory regime that will bring corruption and privilege? Most poorer countries simply cannot count on good and honest regulation, and they don’t have Joe Stiglitz as the main economic advisor to their Presidents.