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Glass-Steagall: Good for Competition, the Economy…and for Banks, Too

November 03, 2016
Donald Trump snuck an unexpected banking policy into his party’s platform. He called for bringing back Glass-Steagall, which he said “created barriers between what big banks can do.” [1] Whether a Trump administration would really push for this change is debatable—the platform also aims to repeal the Dodd-Frank Wall Street Reform Act and Trump has since called for a moratorium on new financial regulations. [2] But the increased publicity has sparked public debate anew about this now-defunct Depression-era law.

By Samantha Waxman

Given the hype, now is an ideal time to examine the merits of this policy proposal. I’ll first consider why Glass-Steagall was passed and how it was undone, and why bringing it back in some form may be good for the economy.

The Glass-Steagall Act of 1933 created a firewall between investment and commercial banking. Commercial banks, which took in deposits and issued loans, were no longer allowed to deal in securities and vice versa. The law’s purpose was to limit the type of speculation that crashed the global economy in 1929. According to the Federal Reserve, the law aimed to encourage productive investments in industry, commerce, and agriculture. [3]

The Gramm-Leach-Bliley Act of 1999 repealed this firewall as part of a larger package of deregulatory reforms. Bank holding companies can now incorporate investment banking into their operations, although investment banks are still not allowed to accept insured deposits.

Did the repeal of this law cause the financial meltdown in 2007? It’s difficult to say. Nobel-laureate Joseph Stiglitz thinks that risky investment banking culture won out when commercial and investment banking were combined pre-crisis.  Others, like former Treasury Secretary Tim Geithner, argue that other factors contributed more, such as mortgage underwriting standards. What is certain is that changes in the law allowed big banks to become bigger and created a bigger appetite for risk in pursuit of profit. [4]

A champion for the law is Luigi Zingales, professor of entrepreneurship and finance at the Booth School of Business at the University of Chicago. Many of the bank failures during the financial crisis were in investment banks so he didn’t think much of it then. His views changed when he started researching his book, A Capitalism for the People.

“I realized that one of the biggest negative effects was that [undoing Glass-Steagall] converged interests in the banking sector,” he said. “In the old days, different points of view made the system more balanced.”

According to Zingales, the consolidation of the financial sector has also increased its political power. “As a company, I’m afraid when my lenders are too concentrated and too powerful. If I’m a borrower, I don’t like that. I want to have [the banking industry] segmented and not so politically entrenched,” he said.

Zingales is also concerned about problems spreading from one part of the banking system to another without Glass-Steagall to stop them. “If markets and banks are integrated, the shock propagates from one to another. If they are delinked, there is more resiliency in the system and one can partially substitute for the other,” he said.

Zingales’ views are more widely shared in the finance industry than they may seem. Just last week, I had conversations with two separate Wall Street insiders (both of whom have requested to remain anonymous). They each told me that they support bringing back Glass-Steagall, but that they cannot speak publicly on the matter. They both think that many others in the industry support their views.

There are several important reasons to bring back Glass-Steagall.

  1. It would restore competition to financial markets. The consolidation in the banking sector since the 1990’s has not only created a class of “too big to fail” banks, it has also boosted these banks’ abilities to extract economic rents and get rid of competition. Glass-Steagall would help small banks compete with the bigger banks, as Akshat Tewary wrote in American Banker. [5] Capitalism only functions when markets allow for real competition, and Glass-Steagall would fight market concentration in the finance industry.
  2. It’s easier and cheaper to put in place than the Volcker Rule. The Volcker Rule, a key piece of the Dodd-Frank Wall Street Reform Act, aims to ban proprietary trading, or the practice of banks using their own funds to make risky bets. It’s a good idea, but its implementation has been long-delayed and the rule itself is overly complex and riddled with loopholes from industry lobbying. If these two activities were separate to begin with, it would be easier and cheaper for banks to comply.
  3. It’s bipartisan. Politicians on the right and on the left have advocated for bringing this reform back including Elizabeth Warren and John McCain (who co-introduced the 21st Century Glass-Steagall Act together in 2015), Bernie Sanders, and now Donald Trump.

Separating “boring banking” from “gambling,” as Elizabeth Warren puts it, it isn’t a panacea. [6] But it is an important step with significant support. We should bring it back. 

References

  [1] GOP platform to call for return to Glass-Steagall. The Hill. http://thehill.com/policy/finance/288148-gop-platform-to-call-for-return-to-glass-steagall

  [2] Trump to Propose Moratorium on New Financial Regulations. Bloomberg Politics. http://www.bloomberg.com/politics/articles/2016-08-08/trump-to-propose-moratorium-on-new-financial-regulations

  [3] Banking Act of 1933, commonly called Glass-Steagall. Federal Reserve History. http://www.federalreservehistory.org/Events/DetailView/25

  [4] Fact Check: Did Glass-Steagall Cause The 2008 Financial Crisis? NPR Political News. http://www.npr.org/sections/thetwo-way/2015/10/14/448685233/fact-check-did-glass-steagall-cause-the-2008-financial-crisis

  [5] A New Glass-Steagall Would Be Too Good for Banks to Pass Up. American Banker http://www.americanbanker.com/bankthink/a-new-glass-steagall-would-be-too-good-for-banks-to-pass-up-1078262-1.html

  [6] Elizabeth Warren: ‘Banking Should Be Boring’. Wall Street Journal MoneyBeat. http://blogs.wsj.com/moneybeat/2013/07/11/elizabeth-warren-banking-should-be-boring/

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