Going back to Glass Steagall Act

Though Volcker rules have in a way gotten back to Glass Steagall, this paper by Jan Kregel of Levy Institute advices against going back. 

Dimitri Papadimitriou, President of Levy Institute provides a summary in the beginning: 

 

Senior Scholar Jan Kregel provides an in-depth account of the Act, including the premises leading up to its adoption, its influence on the design of the financial system (e.g., formalizing the difference between the short-term and long-term use of funds), and the subsequent collapse of the Act’s restrictions on securities trading (deregulation). He concludes that a return to the Act’s simple structure and strict segregation between (regulated) commercial and (unregulated) investment banking is unwarranted in light of ongoing questions about the commercial banks’ ability to compete with other financial institutions.  

In essence, the Act provided the unregulated investment banks with a monopoly over securities market activities. Moreover, both the commercial and investment banks provide liquidity: the former by creating deposits and the latter by structuring the liabilities issued by borrowers. Thus, investment banks were functionally equivalent to the deposit and liquidity-creation business of regulated banks. While the Act provided monopoly protection for the commercial banks’ business model, which was locked into issuing commercial loans, it did not give these banks a monopoly on the creation of liquidity. Over time, other financial sectors offered similar products with fewer restrictions and lower costs (e.g., through structures such as securitization, the commercial paper market, and money market mutual funds, and through the process of “riskless arbitrage”).  

The commercial banks were under pressure and looked for other avenues to earn. This led to banks moving in other lines of business  which led to the current crisis. 

The regulated banks sought to compete in the marketplace by expanding their lending into longer maturities. Ultimately, the Securities and Exchange Commission allowed these banks to operate affiliates that were neither regulated nor consolidated for financial reporting purposes, while other regulators provided a level playing field that included the ability to engage in (highrisk) activities such as credit derivatives. When the liquidity crisis occurred in 2008, it resulted in a collapse of security values, an insolvency in securitized structures, and a withdrawal of shortterm funding. The safety net that was created to respond to a run on bank deposits was totally inadequate to address a capital market liquidity crisis. 

Kregel says it is not enough to prevent banks from doing certain activities. One should also look at how banks would earn alternative sources of income: 

Kregel observes that an alternative source of revenue has to be found for the regulated banks without undermining their protections, and that regulators, legislators, and the judiciary have to agree on a precise definition and the powers to carry out permissible banking activities. One approach is to recognize deposit taking as a public service and to regulate it as a public utility, with a guaranteed return on regulated costs. Another approach is to treat wealth and transaction services as a public service by a  regulated utility such as a national giro payments system, thus eliminating the need for deposit insurance and the lender-of-last-resort function of the Federal Reserve. 

A highly insightful paper on the burning issue. The paper also tells you the kind of pressure banks put on regulators to help them create other entities which helped them earn other incomes. The regulators gave in after some time. This then sowed seeds for the crisis. The problem was not Graham Leach Biley Act but the deregulation mindset before it. 

Despite the interesting history of Glass Steagall, the depth of this crisis will push policymakers to make Volcker rule kinds of policies. The crisis is just too big to ignore. Another lesson from this paper is the importance of having strong regulators. Otherwise, regulatory arbitrage and pressures would once again begin.