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Me in 1985: The Glass-Steagall Act should be repealed.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Me in 1996: It doesn’t seem to matter that much that they haven’t repealed Glass-Steagall.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  I’m sure glad they repealed the Glass-Steagall Act.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?

Comments

Interesting to note that Jim Leach was the driving force throughout the 1990s for repeal of Glass-Steagall, and he was also arguing for a strong regulator of Fannie Mae and Freddie Mac back in the early 1990s. (See this recent Washington Post article : here ).

Not sure what I'm implying, but since I haven't been around as long as Tyler and therefore don't have a history of thought, being provocative is the best I can do.

Gramm-Leach-Bliley allows bank holding companies to engage in investment banking activities. The FDIC-insured bank entity is still pretty well segregated. Unless the Fed allows troubled bank holding companies to raid their bank subs, it's unlikely that deposit insurance could be used to bail out an investment bank.

I've seen a lot of commentary in the past few days trying to attribute the financial crisis to Gramm-Leach-Bliley. There is absolutely no logic to it, just a vague insinuation that there must be some connection between deregulation of the financial industry and a financial crisis that hits ten years later.

I think it works like this:

Banks are able to take deposits at very low rates in part because of the FDIC insurance. Retail banks have a limited set of choices in how they can invest their depositors money. The FDIC knows this, and has some sense for the magnitudes and probabilities of such losses. It gives them a sense for how much to charge for their insurance. Investment banks have a much more complex set of choices. Figuring out how much to charge for investors in that space is more difficult, maybe impossible. SIPC tries to do it with broker dealers, but they only have to protect against a smaller set of worries since loss of principle from market movements is not covered.

Financial crises are a lagging indicator...

Um, dg, please stop foisting a bunch of your POVs upon others, trying to decide what's best for a bunch of socialists.

Probably not much. Pure plays are doing much worse than the big hybrids. Can't imagine Gramm-Leach-Bliley being bigger than, or a decisive contributor to, poor risk management, liquidity gluts, or the real estate bubble.

Moral hazard is a large bank being too big or intertwined to fail on purpose/by design, and then taking large risks to max returns & compensation while taxpayer and other market participants bear downside risk. Are you referring to something else? I apologize if so.

Dr Doctrinaire,

It's your job as an economist and educator to expose economic error and instruct the unlearned

What are you waiting for?

Being too big to fail just means the government might step in and guarantee liabilities, equity is still wiped out. Also, if anything, Glass-Steagall kept banks smaller. I feel like I'm missing somthing here.

Seems to me that we need to limit FDIC guarantees to very simple, transparent structures.

If that means we have to further isolate part of Bank of America and JP Morgan Chase from the other part, so be it.

I believe the moral hazard some are referring to comes from the fact that since the deposits in the i-banks are now somewhat insured by the FDIC, they aren't held accountable by some investors. I doubt this is a big issue though, since most of the deposits in these large banks are from other institutions, who pressure the banks to keep their balance sheets in check.

Sorry. It should be patently obvious to the most casual observer that the repeal of the Glass-Steagall act had significant negative consequences for the financial markets. Patently obvious years ago, as early as the year 2000. Spooky.

"I believe the moral hazard some are referring to comes from the fact that since the deposits in the i-banks are now somewhat insured by the FDIC, they aren't held accountable by some investors. I doubt this is a big issue though, since most of the deposits in these large banks are from other institutions, who pressure the banks to keep their balance sheets in check."---Stanfo

I'm afraid the problem runs deeper than your analysis, set out in your to-the-point language.

You see, the Fed --- increasingly worried about excessive leveraging throughout our financial system --- began in August 2008 to relax the strict rule that kept a retail bank with investment subsidiaries from using FDIC insured deposits for investment purposes . . . and that meant, additionally, from supplying funds out of the insured deposits of consumers and small businesses to their hard-pressed investment partners. And just yesterday, as a "presumably" temporary measure, the Fed explicitly began to urge the big banks to shift deposits toward their more hard-pressed subsidiaries --- a suspension of the hitherto rule that is intended to try injecting more liquidity into the over-leveraged parts of the financial system.

.....

Whether this is good or bad depends on your reading of how desperate the liquidity- and credit-crunch happens to be. I think it is a good thing, considering that there isn't much liquidity left in the financial system beyond, it seems, the insured deposits and, it's worth noting, the ownership by creditor-depositors of Treasury securities (backed by the government whatever happens to the institutional firm selling them), plus CD's, trusts, and 401K retirement funds . . . up to the limits set by the FDIC.

It's a good thing why?

Leave aside Bernanke's impressive empirical studies of the Great Depression and what happened to the entire US financial system in the 1930s . . . all of which give him a knowledge, unlike those being voiced in this and most other economic blogs (whatever their orientation), about a financial crisis of the sort we face that doesn't just rely on robotic, gut-like inferences drawn from a few simple theoretical premises. That's true not just of libertarians, but others.

No, leave it aside. The continued financial crisis enveloping Japan since 1991 --- which goes back to the collapse of its real-estate and stock-market ballooning of the 1980s --- shows what can happen to a country whose economic and political leaders fail to de-leverage a financial system out-of-control other than by a relentless cycle of deflation, followed by a brief spurt of growth --- ballyhooed as Japan finally back to solid growth --- followed by a new recession and more uncertainty, financial and otherwise.

.....

What follows?

We need, as the Fed and the Treasury are doing so far, to emulate what we recommended throughout the 1990s and after to the Japanese: sanitize your financial system one way or another, or otherwise it's curtains for you, pal.

And if we're lucky, all the ballyhooed financial innovations touted by free-market enthusiasts since the early Reagan period --- which have caused one dislocation after another, the speed of those dislocations intensifying the last decade --- will finally be brought under far more regulatory restriction.

.

After all is said and done, please remember. The aim of financial institutions isn't to devise all sorts of wondrous financial instruments --- some so complex I don't if 2% of financial investors and advisers could give you a clear summary --- that make all sort so of vast sums of money for their genius-heads (like the 24 top hedge-fund heads who earned more last year than the Fortune 500 CEOs). No, the aim of such institutions is straightforward:

* Allocate capital efficiently.

* And manage risk effectively throughout all phases of the business cycle.

....

Michael Gordon, Aka the buggy professor

The neutering and ultimate repeal of one of FDR's most important acts of the first 100 days of his administration took place over more than a decade and was supported by Republicans and Democrats alike. Paul Volcker was an outspoken opponent against liberalizing the interpretation of Glass Steagall and its repeal. Alan Greenspan, a former JP Morgan chieftan and later head of the Fed liberalized the Fed's interpretation of the GS Act and supported it's repeal. Sandy Weill and John Reed of Citigroup paid lobbyist huge sums to pressure the govt to repeal Glass Steagall and Sandy Weill personally spoke with President Clinton, Fed Chairman Greenspan and others about his desire to have Glass Steagall repealed. Presiden Clinton signed Gramm-Leach-Bliley into law effectively repealing the Glass Steagall Act.

Republicans and Democrats both have culpability in the repeal of Glass Steagall. If O'Bama is smart he'll remind voters about FDR's first 100 days and the effectiveness of Glass Steagall for more than 70 years and lay out a detailed plan for his version of re-instating a new version of Glass Stegall with the help of Paul Volcker thereby getting the U.S. Govt back into the business of regulating financial institutions and protecting tax payers and depositors from the stupidity and greed of the knuckle heads on Wall Street. Americans are smart enough to know that you hire democrats when you want to create regulations and bureaucracies and bring soldiers home from wars. You hire Republicans when you want to bust unions, privatize government functions, temporarily suspend certain civil liberties, award no bid contracts and successfully wage wars.

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