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?


I nominate this for best Alex posting. Even handed and I pretty much agree. I think that the zeal for glass-steagall is the misguided belief that it will prevent banks from getting too big to fail.

And yet where has Alex been in the Brown-Vitter debate, which almost certainly WOULD deal with all of these problems? He's been silent, of course. Tyler came out obliquely for equity requirements a year or so ago, although he too has been silent.

The obvious implication of course is that it's everywhere and always easier to be against policy than for it.

I'll second this. The basic problem is that banking is really complicated and hard for even moderately informed non-experts to understand. When the banking sector is getting bigger and bigger but the economy isn't growing too much (which is what was happening from 2000-2007) and then the economy crashes, it's natural to conclude that there is something wrong with banking. But it's very easy to come to the wrong conclusion about what the problem is.

This post is an example of missing the point, or at least some of the points. Sure the Shadow banking system played a key role in the crash. Having an equal if not larger issue was the interconnnectedness of the major banks. A recurring argument in the crisis was

"We can't let firm A go under, because it would bring down B, C, and D"

AIG was frequently citied as a specific case. If AIG was allowed to fail, it would have (supposedly) crashed a long list of other financial firms.

A related issue is/was complexity. Supposedly, financial firms were too complex for bankruptcy or even reorganization / receivership. I never saw any plausible reason for rejecting receivership. However, contrary arguments were frequently made.

Restoring Glass-Steagall would diminish both complexity and interconnectedness. Both are virtues in creating a more stable and responsible financial system. Perhaps more relevantly, a financial system with lower levels of complexity and interconnectedness can better tolerate bankruptcy, liquidation, etc.

Peter Schaeffer,

I am afraid you are the one who has badly missed the point. Your analysis conflates two very different kinds of "interconnectedness." The issue you describe as "We can't let firm A go under . . ." etc is a result of counter-party risk. The idea there is that firms B, C and D are dependant on firm A paying its bills. If firm A failed to pay its bills the others might fail as well since they too would be unable to pay their bills.

Glass-Steagal does absolutely nothing with respect to this type of "interconnectedness" or "complexity." In its most notable aspects, G-S prevents deposit taking banks from owning investment banks or engaging in certain types of proprietary trading. During the post-Lehman crisis, the absence of G-S facilitated efforts to contain the meltdown and minimize government involvement in saving banks. B of A was "allowed" (virtually forced) to buy Merril Lynch and Countrywide. JP Morgan Chase was allowed to purchase Bear Stearns. If this had not happened, the problem of "we can't let firm A fail" would have been much worse.

Restoring G-S would do nothing whatsoever to reduce complexity or interconnectedness in the relevant senses of those words. It would, in fact, make the system as a whole more vulnerable. Who would have bought Bear Stearns or Merril Lynch if G-S was in place? What would have happened if those firms had gone the way of Lehman?

And plenty of deposit-taking banks with little or no "shadow banking" exposure went bad during the crisis. WaMu, Downey Savings, IndyMac, ect. all went kaput by making or buying loans backed by residential real estate. They got into trouble doing the thing they were supposed to do, and would have done, G-S or no G-S. It was bad loan underwriting standards, not "interconnectedness" or "complexity" or any other damn buzz-word you want to name, which caused the crisis. People took on too much debt and couldn't service it. The banks lent too much to people that couldn't pay. The "shadow banking" "non-bank run" was a consequence of the crisis, not a cause.

Just to add to your comments, Glass-Steagal, and perhaps even Brown-Vitter, wouldn't have helped much for a liquidity call crisis on the scale of '08-'09. They would have to work indirectly, by discouraging the development of shadow financing relationships despite the current account flows we saw through the '00s. Deposit stickiness becomes questionable when Libor-OIS jumps above 300 basis points without an appropriate monetary response. The intermediary's role changes when everyone rushes for currency and risk-free assets.

Glass-Steagall is popular because it has a name that is short and easy to remember, and people heard it a whole bunch during the crisis. It allows for a potent mix of rational ignorance and pseduo-informed showing off that appeals to people. That's all it is.

+1, sadly

Assuming a new Glass-Steagall won't make anything better, will it make anything drastically worse?

Point being, if someone needs to show off some action to the plebes, Glass-Steagall may not be the worst thing they could do. I'm trying to find the silver lining here.....

Yes, a new G-S would clearly make things worse. If G-S had been in place in 2007 who would have guaranteed the obligations of Bear Stearns and Merril Lynch? If those firms had not been purchased by deposit taking banks, an event which would have been prohibited by G-S, we would have had Lehman II followed closely by Lehman III.


"Yes, a new G-S would clearly make things worse. If G-S had been in place in 2007 who would have guaranteed the obligations of Bear Stearns and Merril Lynch?"

Wrong question. Who did guarantee the obligations of Bear-Stearns? From "JP Morgan Pays $2 a Share for Bear Stearns".

"The cut-price deal for Bear Stearns reflects deep misgivings about its future and the enormous obligations that JPMorgan is assuming in guaranteeing the firm’s obligations. In an unusual move, the Fed will provide financing for the transaction, including support for as much as $30 billion of Bear Stearns’s “less-liquid assets.”"

From Wikipedia

"On March 14, 2008, the Federal Reserve Bank of New York agreed to provide a $25 billion loan to Bear Stearns collateralized by free and clear assets from Bear Stearns in order to provide Bear Stearns the liquidity for up to 28 days that the market was refusing to provide. Apparently the Federal Reserve Bank of New York had a change of heart and told Bear Stearns that the 28 day loan was unavailable to them. The deal was then changed to where the NY FED would make a $30 billion loan to J.P. Morgan (collaterallised not by any J.P. Morgan assets but collaterallised by Bear Stearns Assets), who would buy Bear Stearns for 2 dollars per share.[19] Two days later, on March 16, 2008, Bear Stearns signed a merger agreement with JP Morgan Chase in a stock swap worth $2 a share or less than 7 percent of Bear Stearns' market value just two days before.[20] This sale price represented a staggering loss as its stock had traded at $172 a share as late as January 2007, and $93 a share as late as February 2008. In addition, the Federal Reserve agreed to issue a non-recourse loan of $29 billion to JP Morgan Chase,[21] thereby assuming the risk of Bear Stearns's less liquid assets (see Maiden Lane LLC). This non-recourse loan means that the loan is collateralized by mortgage debt[22] and that the government can not seize J.P. Morgan Chase's assets if the mortgage debt collateral becomes insufficient to repay the loan.[22][23] Chairman of the Fed, Ben Bernanke, defended the bailout by stating that a Bear Stearns' bankruptcy would have affected the real economy[24] and could have caused a "chaotic unwinding" of investments across the US markets.[20]"

Evidently, you don't read or understand the stuff you find on the internet.

Yes, the Fed finance the deal and since the loans were collaterized only to the original Bear Stearns assets, the Fed might not get all of its money back if the deal failed. The Fed was at risk to the extent that the Bear Stearns collateral was not enough to cover the Fed's loans. However, that also would have been true if the Fed had directly bailed out Bear Stearns as the original deals contemplated. Instead, JP Morgan took Bear Stearn's counter-party risk on to its balance sheet. If losses on Bear Stearns' open trades exceeded the Fed loans, JP Morgan would be at risk. Obviously, somebody at the Fed thought this was possible since they backed out of the original deals.

Which situation do you want: (a) Bear Stearns files BK (the Lehman scenario); (b) Fed bails out Bear Stearn by itself (the AIG scenario); or (c) JP Morgan takes Bear's risk (and assets) with Fed assistance? Even if you prefer (a) or (b), is the system as a whole made more stable if option (c) is permanently taken off the table as a result of a renewed Glass-Steagal?

Wouldn't G-S have prevented firms like Merril and Bear from becoming so systemically important to the banking system in the first place> The idea of separating commercial and investment banking seems like a way to allow speculators to confine their risk taking to areas of the economy that would not, in the event of a crash, substantially damage the average deposit holder. Why were the fates of large depository institutions so dependant on the health of investment houses like Goldman and Morgan Stanley?

I believe the polite term for "rational ignorance and pseduo-informed showing off" is "marketing".

Exactly. I'm puzzled that Alex is puzzled that professional politicians and their courtesans, whose success relies on popularity, would produce superficially attractive solution to a popularly perceived problem. Like Eric Holder speaking against Stand Your Ground laws, nothwithstanding their irrelevance to George Zimmerman's acquittal. Similar examples are as numerous as mosquitoes.

Cargo-cult economics. If we would just re-instate G-S, John Frum will return to bring low the bankers and raise up the little people. Union membership will rise, manufacturers will climb all over themselves to built things in the United States, and it will be just like the 1950s (except without all that nasty endemic racism and sexism).

First off, excellent post. Second, the reason the folks in the pews are chanting Glass-Steagall is it is now a part of the liberal hymn book. None of them know what it was or even what it means. They believe it means the sainted Obama gets to manage the banks so they will stop be greed-heads. As for Lieawatha Warren, she does not know the first thing about the banking system.

Now, I think you are wrong when you say the Fed is unaware of who is emitting massive amounts of credit. The Fed is one of the worst offenders and has deliberately enabled the shadow banking system. Back in the Clinton years when there was some attempts to reign it in, the Fed took the point on fighting these measures in Congress. It is time to admit that the central Bank has always been a tool of the big banks and the shadow banking system that lies beneath the waves.

The solution is one dollar of capital for every dollar of credit. No more creating credit out of thin air.

"Greed is bad. Let's pass a law banning greed." is about as nuanced as most progressives ever get.

The most compelling argument I've gotten about how the repeal of Glass-Steagall caused the crisis boiled down to "the banks wanted it, and when they won they got full of themselves and then did a whole bunch of other bad things." So returning Glass-Steagall is not about good regulation, but lowering the status of the banks, so maybe they will be less cocky.

No, I'm not convinced either.

Good banking regulation is freaking hard.

Best way to "regulate" the banks is to remove the protections provided by the corporate form for the largest institutions. If your bank is TBTF then the employees (and recent employees who were involved in open/live transactions) are on the hook for the banks debts. After all the employees, directors, board members, executives are zeroed out then proceed with whatever other measures are necessary.

Additionally, any such employee who has assets outside US jurisdictions should be imprisoned until those assets are repatriated.

Any institution that must be rescued by the public is in a different class than smaller non-TBTF corporations and there is no reason to think that they should have the same legal protections. With Great Power Comes Great Responsibility, or something.

I mean imprisoned in the event of a failure and a bail out.

The solution is one dollar of capital for every dollar of credit. No more creating credit out of thin air.

Great news - we've got a cure for cancer. All we do is stop any cell in your body from reproducing... Problem solved.

Baloney. Credit is money. You can't have sound money if various parties are creating money out of thin air, which is what you have now. If you want to expand the money supply, it must be done transparently.

You can have deregulated credit markets -- credit created out of thin air -- and still have sound money. But, you must give up the illusion that the Fed actually controls the money supply.

The Fed controls a couple of levers that can move the money supply.

You're puzzled that the proposed response to a problem would not actually have prevented the problem? Is this your first day in the United States? :)

Some people might think that Paul's comment was sarcastic, but Alex is trying to apply logic to the illogical.

Alex, I think you misunderstand why reintroduction would be good. Simply put, it would remove the free put that investment banking activities have (courtesy of the US gov't). By separating them, you would remove that option and increase the default risk - and therefore curb risk taking... in theory.

Alternatively put, low cost of capital was (is) arguably one of the root causes. Without access to commercial bank balance sheets the investment banking arms would have been unable to extend risky practices in the shadow banking world as far as they did.

Obviously not a hail-mary solution but certainly would have helped diminish what happened in the crisis.

I think you see the problem correctly - it is Fed policy to reduce the cost of capital. Without that policy, the craziness could not happen like it did (does). And with that policy, no other law will prevent the craziness from happening (again).

The risk premium is separate from the actions of Greenspan holding down the cost of capital (regardless of whether this helped the crisis). It is the risk premium to the underlying cost of capital that was lower due to amalgamation of banking activities.

A few possible objections to your statement:

1. I'm fairly certain that under current regulations, investment banks did not have direct access to the balance sheet of their paired commerical bank.

2. Commercial Banks and Investment Banks are still regulated individually and accordingly; the strength of one does not compensate for the weakness of the other. There's just a Bank Holding Company that owns both and is regulated separately as well.

3. A commercial bank is always allowed to at least lend to investment banks (or any shadow entity for that matter) it's not directly affiliated with, and still would be after a new Glass Steagall.

4. AIG, Freddie and Fannie, GM and Chrysler all received "free puts" despite being nowhere near these regulatory regimes, so now what?

1. They effectively did. The cost of capital within investment banking operations is much lower than a standalone shop. Source: I have worked in investment banking/trading at some of the worlds biggest banks. If they had to borrow externally/on their own balance sheet then things would be much more expensive.

2. Are you suggesting there are separate Tier 1 ratio/Basel/whatever requirements for each part of the company? This is not the case.

3. This is a good point. The question is: why would they want to? The old way revolved around a profit center (investment banking) and standard banking. The commercial bank benefitted from higher profit. If they were just lending then they would need a higher rate... which brings us back to: Glass Stegall would raise the cost of capital for investment banks and curb risky practices.

4. Agreed. Though GM/Chrysler vs. AIG vs Freddie/Fannie are three separate issues. AIG being the only one really relevant to the topic at hand. I merely argued that Glass Stegall; would have curbed risk taking practices in banks and mitigated some of the damage done by the crisis.

Okay, I see where you're coming from better now.

1. I'll take your word for it. We could solve this issue tomorrow by mandating that they have to borrow externally - and then all the banks pretending they just want to sell IRAs to retail bank customers can continue their charade.

2. That's what I thought - maybe I'm wrong. I've never seen a hybrid capital requirements regulation - only separate for each part. The investment bank Net Capital Rules and Fed/FDIC requirements don't seem compatible at all. But maybe that bizarre "consolidated supervised entities" exception that the largest banks got in the early 2000s had a merged Basel II deal. Needless to say I'm confused on this point now.

3. Fair enough! But given pretty much all of the failing investment banks were standalone, it seems we haven't solved that at all - just a theoretical combined bank collapse. And I thought just about all the trouble was on the commercial/retail banking side of Bank Holding companies.

4. I'm just saying that when things get out of control, the government is going to (probably) bailout anything and everything that they feel like. It's especially frustrating as this seems largely dependent on whether the market took it upon itself to presume the government would bail them out.

Thanks for your insights.

Wasn't one of the concerns about banking conglomerates like Citi and Bank of America that allowing them to fail would jeopardize the deposits of their retail customers? I agree that most of the people arguing for a return to Glass-Steagal are supporting that position with poor reasoning (see Benny's post above), but it doesn't strike mas a completely insane proposal.

It would be one small piece of the puzzle. There's a public interest in regulating credit as credit is money. Not all credit is the same. Asset backed lending like mortgages is nothing like underwriting public debt issuance. That means different rules and that should mean different regulators. Separating all of these different operations is a necessary step in any reform plan, just from a logistical point of view.

Warren is just playing to her fans ignorance about government regulations. Glass steagall was deregulation and all crises created by business is from lack of regulation. The details don't matter to them.

Please don't assume that Warren isn't just as ignorant as her fans.

2nd your point- I think Warren is given way too much credit for brains. Her major writings have been debunked & she clearly used the diversity ladder aggressively to move up the academic chain. Little evidence for significant accomplishment other than fully utilizing the system. Her ignorance of basic accounting principles in the student loan program is awe inspiring.

Thirded. Like all feminist heroes, Warren married well and rode her husbands success to the top. Otherwise, she would be defending drunk drivers from a strip mall office in Oklahoma.

It makes sense if your goal is to seem to affect (although with inventive lawyers, the actual effect will be nil) the banks people have heard of, as opposed to the much larger (in aggregate) shadow banking sources nobody has ever heard of.

What's going on is really a manipulation of symbols. The repeal of Glass-Steagall has become a symbol of deregulation and by proxy libertarian capitalism in general. Reinstating Glass-Steagall would thus symbolize a repudiation of libertarian capitalism. To summarize the thought process : "We hate capitalism, therefore Glass-Steagal".

The preferred narrative for Elizabeth Warren and other like-minded politicians, pretty much from the start, was that the crisis was caused by deregulation run amok. It's only natural for people to ask, "Well, which regulations do you mean?" and Glass-Steagall became their go-to answer. It had a catchy title (can you imagine trying to push "Regulation Q" as the answer? People might think it had something to do with puppets making dirty jokes), it was repealed at approximately the right time, and it was clearly associated with banking. It also helped that it had a storied history, as part of the response to the Great Depression. It didn't really matter that the timing was very approximate (Continental Illinois and the S&L crisis predated it by about a decade), or that the institutions that precipitated the crisis were in compliance because nobody ever bothered to ask how GS would actually have helped. Before too long it turned into a question-begging argument: GS must have been the key to preventing the crisis because everyone is talking about it, and why would they be talking about it if it weren't the key to preventing the crisis? And so it goes, and so we get regulations that sound good on television news pundit shows instead of regulations that might actually solve the problems they're intended to address. In other words, business as usual in a 21st century democracy.

How about banning all borrowing and unsecured derivatives altogether?

The only forms of securities would then be equity, full-reserve deposits or derivatives with all deliverables held in escrow.

This means that defaulting is no longer possible, and thus it's no longer possible to have any financial crisis.

Businesses can still raise capital in the form of equity investments.

There would still be debt, either in securitiesed (bonds) or unsecuritised (loans) form.

If there is debt, there will be defaults.

If you are talking about getting rid of debt financing you are talking about something monumental. How will people buy houses? or cars? 100% cash?
How will governments finance themselves?

No, bonds and loans would simply not be enforceable contracts (or perhaps even outright illegal).

You rent houses or lease cars if you can't afford to pay in full.

Governments do not really need to finance themselves as long as they don't spend more than the tax revenues for that year (plus an exception allow to roll over existing debt with a plan to pay it all off); if governments really want to finance themselves, they can sell equity-like instruments, like a percentage of tax revenues or some future years.

Regarding student debt, you sell X percentage of your wage in the first N years after college in exchange for free college.

I don't think debt is really useful aside from masking risk in a way that causes regular crises and allows some people to pocket bailout money.

Chris Cook, in his work on open capital has described a structure which can be used for capital investment.

Two partners, one who has the money and the other who uses the asset, enter into an equity partnership and decide on the schedule of the re-assessment of the asset's value and the rate of return to capital. The user or active partner pays the rent decided by multiplying the rate of return with the asset value. The rent gets divided up as the percentage of the equity. Any payment from the active partner more than his share of rent ends up in the active partner increasing his equity and reducing the equity percentage of the financial partner. There can be variants on this if some maintenance is done by the active partner. The active partner could build up sweat equity that way.

The financial partner/financier is deeply concerned about the longterm financial value of the asset since he holds an equity share all the way until the active partner has fully paid out.

For consumer finance, this cannot be used. Consumer finance is discouraged in this model.

So, Shariah law basically?

Hopefully not - the lawyers have figured out ways around Shariah.

Is she still around? Why? And why is Holder still around?

Wasn't the cause the housing bubble and the precipitating event when the dumb money (banks) got in on the housing bubble? Occam's razor dictates the null hypothesis to be the money creation monetizing the house price run-up. So, I think a lot of the thinking is bass-ackwards because houses aren't risky until someone who can overpay for them gets involved.

Um...because the people of the Commonwealth of Massachusetts decided it would be a swell idea to take her on as a senator.

Although I do agree it is misguided to place emphasis on Glass-Stengel, one of the worst too big to fail banks, Citibank, was the primary reason for its repeal. Basically, now it feels like the entire economy needs six institutions to make absurd amounts of money and the FDIC/taxpayers must protect them from failure. And I do agree with Krugman that right now Republicans talk a good game of ending TBTF bailouts, when the rubber hits the road in 15 years, they will again buckle to the needs of the largest institutions.

Living wills. I.e., government please do your job of delineating property rights and entitlements.

Oh, and is Chuck Schumer talking a good game? What's funny is that if the government can only manage 6 incumbent financial firms, what does that say about their ability to manage top-down regulation when there are more than 6 relationships to manage?

Everyone talks a good game about ending TBTF, but no one is willing to risk another recession by letting them fail when the time actually comes.

Not just Republicans, Democrats talk a good game and then pull stunts like this instead. You really think Democrats wouldn't buckle like they did in the last crisis?

And note that Warren could stick it to the banks by preventing their further growth or even reducing their size over time - instead she chose this.

The point of Glass Steagall is not to stop a future run on the shadow banking system. This is near impossible to do without draconian regulation. The point is to insulate the taxpayer and the ordinary depositor from the consequences of such a run. It also has the happy side effect of preventing the shadow banking system from profiting from the implicit backstop provided by the taxpayer.

Doesn't that presume that only commercial banks can be deemed "systemically important"? In other words, if the shadow banking system (newly separated from commercial banking by a resurrected Glass-Steagall) gets into trouble going forward, will the government be willing to just let the investment banks collapse? They weren't willing to do it last time, and I don't see them being willing to do it in the future.

The thing is that during the financial crisis there was never really much threat to ordinary depositors. Those are all FDIC insured and nobody was suggesting the FDIC wouldn't be fully financed. That was never the issue and was never the reason for the bailouts. The concern was about the impact on business lending, mostly big business.

How exactly would it stop depositors and taxpayers from consequences? One institution doesn't need to own another to have counterparty risk. Goldman Sachs didn't own AIG, but AIG almost brought down Goldman, so the government stepped in and bailed it out.

I kind of think it was the other way around. Goldman brought down AIG.
To describe it loosly, Goldman insured all their assets against financial losses using products sold by AIG. The risk of those losses was vastly understated because of the poor ratings provided by the ratings agencies. So either AIG was going to fail and Goldman was going to take the loss, or AIG was going to get bailed out. AIG ate the loss and got bailed out by the Federal government, which allowed them to make good on their commitments to Goldman, which made Goldman whole.

It is a question of perspective, but the point still remains. Two financial institutions can be completely separate legal entities and still have lots of counterparty risk with each other. That being the case, how does restoring Glass-Steagall either make the financial system less risky or help to contain risk?

As the theory goes, a Glass-Steagal type of firewall between investment and commercial banking would insulate deposits, because the institution holding them would not be allowed to carry the sort of counterparty risk you mention. Once deposits were insulated, the political will to save all the banks would then in turn be diminished, so the Goldman's of the world would lose their implicit subsidy and stop ramping up the excessive risk.

I don't particularly buy into the theory (particularly the 2nd-order effect on TBTF/implicit subsidies), but I don't think it's wholly unreasonable.

Goldman was not a bank (I think it created a banking subsidy as a result of the terms of the bailout) It did not have depostitors. They were not FDIC insured.

And AIG is neither a bank nor an investment bank. They are an insurance company.

The current complexity of the system does not fit the 1930s model.

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.”

I have a better (and shorter) one: "tight money".

People need simple stories that reinforce their prejudices. Same reason why conservatives talk about the Community Reinvestment Act.

Why is it I've heard way more liberals saying that conservatives talk about the CRA than I've heard conservatives talk about it? Actually, nevermind, I know why. Conservatives at-large never really put their eggs in the CRA basket, but largely referenced it as a symptom of the problem of extending credit down the credit-worthiness scale to the breaking point. Was there a housing bubble? Did home loans expand? Was government involved in housing finance? Was government incentivizing housing and home financing? If everyone just paid their mortgages, is the crisis averted?

The specific regulations kind of don't matter, but kind of do.
"It isn’t losses from CRA loans that drove the crisis (although they are disproportionately responsible for losses at some banks). Instead, the CRA required lax lending standards that spread to the rest of the mortgage market. That fueled the mortgage boom and bust."

The libs of course want to make this about the Republicans blaming the alleged beneficiary groups of CRA so they can label them as racists.

Personally, I believe low standards of lending work well when the money supply is expand and then suddenly don't work so good in deflation.

Max, Andrew',

If you specifically look at the CRA as a major cause of the Great Recession, you won't come up with much evidence. If you use the CRA as a shorthand for a zillion public sector (and eventually private sector) efforts to promote minority lending by lowering standards, the evidence is little short of overwhelming.

The best summary book on the subject is "Reckless Endangerment". The book is reasonably balanced (making liberals crazy). The following review by George Will is not, but does hit the high points.

"Burning down the house>, Published: July 1

“The louder he talked of his honor, the faster we counted our spoons.”

— Emerson

The louder they talked about the disadvantaged, the more money they made. And the more the financial system tottered.

Who were they? Most explanations of the financial calamity have been indecipherable to people not fluent in the language of “credit default swaps” and “collateralized debt obligations.” The calamity has lacked human faces. No more.

Put on asbestos mittens and pick up “Reckless Endangerment,” the scalding new book by Gretchen Morgenson, a New York Times columnist, and Joshua Rosner, a housing finance expert. They will introduce you to James A. Johnson, an emblem of the administrative state that liberals admire.

The book’s subtitle could be: “Cry ‘Compassion’ and Let Slip the Dogs of Cupidity.” Or: “How James Johnson and Others (Mostly Democrats) Made the Great Recession.” The book is another cautionary tale about government’s terrifying self-confidence. It is, the authors say, “a story of what happens when Washington decides, in its infinite wisdom, that every living, breathing citizen should own a home.”

The 1977 Community Reinvestment Act pressured banks to relax lending standards to dispense mortgages more broadly across communities. In 1992, the Federal Reserve Bank of Boston purported to identify racial discrimination in the application of traditional lending standards to those, Morgenson and Rosner write, “whose incomes, assets, or abilities to pay fell far below the traditional homeowner spectrum.”

In 1994, Bill Clinton proposed increasing homeownership through a “partnership” between government and the private sector, principally orchestrated by Fannie Mae, a “government-sponsored enterprise” (GSE). It became a perfect specimen of what such “partnerships” (e.g., General Motors) usually involve: Profits are private, losses are socialized.

There was a torrent of compassion-speak: “Special care should be taken to ensure that standards are appropriate to the economic culture of urban, lower-income, and nontraditional consumers.” “Lack of credit history should not be seen as a negative factor.” Government having decided to dictate behavior that markets discouraged, the traditional relationship between borrowers and lenders was revised. Lenders promoted reckless borrowing, knowing they could off load risk to purchasers of bundled loans, and especially to Fannie Mae. In 1994, subprime lending was $40 billion. In 1995, almost one in five mortgages was subprime. Four years later such lending totaled $160 billion.

As housing prices soared, many giddy owners stopped thinking of homes as retirement wealth and started using them as sources of equity loans — up to $800 billion a year. This fueled incontinent consumption.

Under Johnson, an important Democratic operative, Fannie Mae became, Morgenson and Rosner say, “the largest and most powerful financial institution in the world.” Its power derived from the unstated certainty that the government would be ultimately liable for Fannie’s obligations. This assumption and other perquisites were subsidies to Fannie Mae and Freddie Mac worth an estimated $7 billion a year. They retained about a third of this.

Morgenson and Rosner report that in 1998, when Fannie Mae’s lending hit $1 trillion, its top officials began manipulating the company’s results to generate bonuses for themselves. That year Johnson’s $1.9 million bonus brought his compensation to $21 million. In nine years, Johnson received $100 million.

Fannie Mae’s political machine dispensed campaign contributions, gave jobs to friends and relatives of legislators, hired armies of lobbyists (even paying lobbyists not to lobby against it), paid academics who wrote papers validating the homeownership mania, and spread “charitable” contributions to housing advocates across the congressional map.

By 2003, the government was involved in financing almost half — $3.4 trillion — of the home-loan market. Not coincidentally, by the summer of 2005, almost 40 percent of new subprime loans were for amounts larger than the value of the properties.

Morgenson and Rosner find few heroes, but two are Marvin Phaup and June O’Neill. These “digit-heads” and “pencil brains” (a Fannie Mae spokesman’s idea of argument) with the Congressional Budget Office resisted Fannie Mae pressure to kill a report critical of the institution.

“Reckless Endangerment” is a study of contemporary Washington, where showing “compassion” with other people’s money pays off in the currency of political power, and currency. Although Johnson left Fannie Mae years before his handiwork helped produce the 2008 bonfire of wealth, he may be more responsible for the debacle and its still-mounting devastations — of families, endowments, etc. — than any other individual. If so, he may be more culpable for the peacetime destruction of more wealth than any individual in history.

Morgenson and Rosner report. You decide."

During the crisis, the Fed simultaneously granted Goldman Sachs bank holding company status and granted a waiver from bank holding company regulations, so that Goldman could enjoy all the benefits and none of the burdens. Years later, Goldman is still negotiating with the government (which, often as not, is headed by a former Goldman employee) over which banking regulations it will accept. Reinstating Glass-Steagall would at least put an end to that.

Great post.

The mythology seem to run that everything was great up until 1999. Then Wall St. went out of control. Hence Graham-Leach-Bliley was the problem.

The notable failures of 2007-2008... New Century, Novastar, Bear Stearns, Northern Rock, Fannie Mae, Freddie Mac, Lehman Brothers, Glitnir Bank, Landesbank, AIG.

Did I miss any? How many were would have received increased regulation from Glass-Steagall? None of them. None of these entities had both significant banking and investment banking arms, or were not American companies.

The only rationale for Glass-Steagall I have heard that makes the slightest bit of sense, is that it would have prevented JP Morgan, Citi, and BofA from becomming "too big to fail." But none of the post-crisis legislation actually tackles TBTF. Instead they have attemted to institutionalize it.

Historical Foot note: my great-grandfather was an aid to Senator Glass and actually wrote most of Glass Steagall.

I actually believe that Gramm-Leach-Bliley softened the blow of the crisis. Don't we all think that the crisis would have been worse – or required more government intervention – if Bank of America and JP Morgan couldn't legally purchase Merrill Lynch and Bear Stearns, respectively?

Smart comment.

Bank of America did require huge amounts of government assistance, and the result is a combined company that is even more TBTF than these entities were pre-crisis. Even if the repeal of Glass-Steagall made the last crisis a little better, it will make the next one much worse.

Too academic a view. It's the conflicts of interest that justify GS.

Chernow's House of Morgan was illuminating in this regard. For GS to work, it probably has to be done on a global scale. JPM was doing investment banking and MS commercial banking in Europe prior to the repeal. No use in separating the two only in the US

"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.”"
Well, that may have been the symptom, but what was the cause? How about this: The finance industry ran out of suckers to fleece.

Here's a rebuttal from Simon Johnson:
"The point of the New Glass-Steagall Act is to complement other measures in place or under consideration, including much higher capital requirements (both in the Brown-Vitter proposed legislation and in the new regulatory cap on leverage now under consideration), the Volcker Rule, and efforts to bring greater transparency to derivatives. " Baseline Scenario

He also disagrees with your assessment of the arguments for/against Glass-Steagall. You say "but because it [Glass-Steagall] is so clearly a policy that doesn’t deal with the problems that created the financial crisis" He says,"The strangest argument against the Act is that it would not have prevented the financial crisis of 2007-08. This completely ignores the central role played by Citigroup...."

Love the condescension from such a expert. Why not post some of your 2007 2008 posts about there being no housing bubble?

Why bring it back? Because politicians don't care about passing something that makes sense.

Indeed, why would anyone think that 1930s policy is the solution to a 21st century problem?

Because people are credit snobs.

Seriously, they are credit snobs. They're idiots, their opinions are not worth anything.

Wake up sheeple.

Wow, old posts sure got a lot of spam!

You never go full Rothbard.

We need some form of Narrow Banking. If not that, you might as well guarantee everything through some form of Insurance. The hope, of course, is that the Guarantee will limit the damage by allowing an orderly unwinding.

"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.”"

I think a better summary would be: "Every banker is at heart a criminal"

Basically, it looks to me like repos are an accounting fiction in order to get around reserve requirements and funding regulations.

Repos' fingerprints are all over the crisis.

We would be in much better shape if we forgot about the reserve requirements, since they are de facto gone now anyway, and treated repos as loans, which is what they are.

It wouldn't require any new regulations, just some honest addendums to accounting standards.

If I understand correctly how they work, repos are also basically a way to get favorable debt financing that keeps all the advantages of federal deposit insurance without technically violating capital requirements.

One of the solutions to the banking issues we had in 2008 was to allow banks to merge. In other words, they would have had repeal Glass-Steagall anyway.

For those of us without economics, bidness or financial training, can anyone recommend a guide to or discussion of "the shadow banking system" that's comprehensible to a layman?

Now that all you snarky, clever folks have congratulated each other to the point of cl!max, the fact remains, Elisabeth Warren is right. Glass-Steagall worked, and we've had nothing but pandemonium since its repeal.

Now the 4 biggest banks are 30% larger than they were in 2008 and we are in greater danger than ever. If I have a choice between Elisabeth Warren and these comments above, the Senator gets it right.

While I take the point that there may be better regulatory solutions, is it really that puzzling that someone might think that getting explicitly publicly-backstopped commercial banks out of the shadow banking game might be worthwhile? The big commercial banks, after all, were a very big part of the shadow banking system via their investment banking affiliates.

Just so we all agree on the problem, the question being asked is what to do with the Shadow Banking Services/Investment Services that would be separated from the Banks as Glass-Steagall did. It's not even clear that GS addressed or anticipated this problem. And why should it? Financial Services have had decades to grow out around GS. In any case, it didn't stop the S& L Crisis, which I see as a precursor to 2008. One final historical point: Many Bankers accepted the Banking Acts because they truly feared Narrow Banking.

Seems the implication of Alex is that a free market in the monetary system and all credit creation must be avoided. That seems a bit at odds with the free banking research so I'd suggest something is being seriously missed in one of the areas.

I'd say I'm more seduced by Simon Johnson on this topic than Tyler. See here:

By not allowing deposit-taking institutions to own/fund investment banks, didn't G/S prevent the shadow banking system from becoming so leveraged? When Investment Banks had to put up their own capital it seemed like they were more prudent in their activities.


I don't agree with this at all.

Surely the central issue is how to prevent a large-scale retail bank from going under so taking ordinary people's money away and putting the whole cash payments system under threat.

Most of the shadow banking system and investment banking system can fail with only a short-term impact on the rest of the economy, if it was separated from retail banking.

The separation of the these banking 'systems' would actually inherently make the likelihood of such a failure far less likely. There is a good reason why the IBs used to be partnerships.

Whether these types of banking can be kept separate in practise is a good question and the banks constant challenge to rules was proof of that. But does anyone think regulating the banks with capital ratios and prop trading rules would be easier? Really?

To push back here is an alternative narrative. Banking regulations and monetary policy of the Federal reserve allowed for insufficient growth of the monetary base. The regulators assumed knowledge as to what should be the "appropriate" quantity of money. Responding to market pressures the market created a grey market to allow for sufficient growth in the monetary base. To the extent that the grey Shadow baning sector dwarfs M2/M3/MZM is the extent of the failure of our current regulatory scheme. The actions of the Federal Reserve and government successfully marginalized their role in affecting the quantity of money.

In this light I see shadow banking as neither good or bad. It is a response to the policy constraints exerted by those that presume to know better. The good thing about the shadow banking sector is that failure cannot be saved. It is too big to bail out, TBTBO. Once the players in the market realize this by suffering some failure, we will see more sound discipline. Any form of regulation that acts to restrict the money creation in the shadow banking sector will force other market innovations, these innovations may not be as stable as if we were to allow more conventional mechanisms for fluctuations in the money supply. To this end, the shadow banking sector is simply an extension of fractional reserve banking. It represents an effective denationalization of the dollar.

When I'm not trying to make a living, or surf the Internet, I'm treasurer of my small New York housing co-op (30 units).

Earlier this year, we refinanced our mortgage, in the $1.5m range. We shopped with a couple of mortgage brokers who introduced us to a couple of banks. One big bank said, a traditional fixed-rate will be X, but you can do a floating-rate and swap into fixed for 30 basis points less.

Pitching tiny co-ops interest rate swaps is effed on so many levels I don't even know where to start. (the true effective rate for the borrower was misstated, there are various scenarios that are very tricky for the borrower, the bank's balance sheet is meaningless as a picture of their exposure)

Your point about the financial crisis being a run on the shadow banking system is well taken, but I think the point is, the taxpayers should not be backstopping the shadow banking system, and the banks should not be selling it as a substitute to unsophisticated players.

My understanding of the pro-Glass-Steagal argument is that it would have contained the huge losses from infecting normal banking and that normal depositors would not have been exposed to risk if banks like Citi had not been allowed to engage in the CDO mortgage securitization business.

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