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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Me in 1985: The Glass-Steagall Act should be repealed.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Me in 1996: It doesn't seem to matter that much that they haven't repealed Glass-Steagall.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 I'm sure glad they repealed the Glass-Steagall Act.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?
Posted by Tyler Cowen on September 15, 2008 at 03:35 PM in Food and Drink | Permalink
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.
Posted by: Philip Wallach at Sep 15, 2008 3:56:51 PM
You seemed confused in 1989. Why would repealing G-S require extending deposit insurance coverage? Did you envision Gramm-Leach-Bliley? Also, are you referring to on-the-book public sector guarantees or implicit promises, such as those made to the Chinese when they bought FF assets?
In two weeks time, will you wonder how much of this episode was caused by the policy event of August 15, 1971?
Posted by: chris at Sep 15, 2008 4:09:19 PM
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.
Posted by: FXKLM at Sep 15, 2008 4:16:38 PM
Would somebody please clarify how deposit insurance could be abused and why Glass-Steagall would have made the current situation worse?
Posted by: Joe Schwartz at Sep 15, 2008 4:29:37 PM
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.
Posted by: OneEyedMan at Sep 15, 2008 4:40:28 PM
Isn't the next step that combined retail/investment banks are tempted to keep the first minimally capitalized, handing their retained earnings (within regulatory capital/segregation guidelines) to the i-bank to get higher returns? In turn, the i-banks and HF clients bid up assets which are on the asset side of the banks balance sheets (loans), and this cycle perpetuates itself since most bank's risk models are pro-cyclical. So the mechanism is indirect but real. I heard that UBS traders where being funded at LIBOR (could be hearsay). What am I missing, as I'm not at all completely confident in the above?
Posted by: Anthony at Sep 15, 2008 4:54:00 PM
Financial crises are a lagging indicator...
Posted by: Dr. Doctrine at Sep 15, 2008 4:58:21 PM
It seems to me that you are all a bunch of socialists, sitting around
deciding what's best for others. What would be wrong with letting
them decide for themselves? Whatever disasters they might inflict upon
themselves would be upon themselves alone, and not everyone else.
A pure free market doesn't mean you couldn't have the government you wanted,
just that you couldn't force it on others, that everyone could make and pay for
his own mistakes, without having to pay for those of others as well, that
everyone could bet his own future, but not that of everyone else, on his own
fallible human judgment.
Posted by: dg lesvic at Sep 15, 2008 5:02:47 PM
Um, dg, please stop foisting a bunch of your POVs upon others, trying to decide what's best for a bunch of socialists.
Posted by: Dr. Doctrine at Sep 15, 2008 5:15:40 PM
Hypothetical: What would have happened this weekend if Glass-Steagall hadn't been repealed? I suppose Merrill isn't swallowed up by BoA and eventually meets it's maker.
What about other effects?
Posted by: Trieu at Sep 15, 2008 5:27:18 PM
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.
Posted by: Anthony at Sep 15, 2008 5:41:31 PM
I fail to see the moral hazard here. The investor is not insured from losses from anything more exotic than CoDs and for deposit insurance to actually kick in the bank has to be way on its way out of business. Where is the moral hazard?
Posted by: Joe Schwartz at Sep 15, 2008 5:44:24 PM
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.
Posted by: Anthony at Sep 15, 2008 5:48:23 PM
Dr Doctrine,
It's your job, as an economist and educator, to expose economic error and instruct
the unlearned.
What are you waiting for?
Posted by: dg lesvic at Sep 15, 2008 5:57:31 PM
Dr Doctrinaire,
It's your job as an economist and educator to expose economic error and instruct the unlearned
What are you waiting for?
Posted by: dg lesvic at Sep 15, 2008 6:00:26 PM
Sorry for the multiple postings.
That was an error.
Posted by: dg lesvic at Sep 15, 2008 6:01:59 PM
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.
Posted by: Joe Schwartz at Sep 15, 2008 6:09:38 PM
Umm these has been my thought process also TC. Why is glass-stegall is needed now because ML should die, its clear that BoA paying a premium doesn't make sense. And do we want the largest holder of individual bank accounts taking on Countrywide and ML in the span of 4 months?
I haven't heard any discussion of what capital they are going to inject to stabilize ML.
Correct me if I am wrong but the impression I get is that at this point the only liquidity in the system are consumer and small business accounts. Thats it the cash sitting in these accounts is the last bastion of liquidity which is why most of the consumer banks have been somewhat insulated at least those that were able to unload the mortgage debt to the iBanks and indirectly the AIGs who insured them and they kept the asset side of the equation.
And at this point if we tally up our balance sheet our we upside down? In which case is Kotlikoff prediction coming true?
Bernanke needs to be wondering, what if China blinks.
Posted by: Mr Glass at Sep 15, 2008 6:41:02 PM
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.
Posted by: ZBicyclist at Sep 15, 2008 8:34:18 PM
Dr. Doctrine said: "Financial crises are a lagging indicator..."
Haha! You made me laugh hard out loud. Thank you for that.
Posted by: djconnor at Sep 15, 2008 9:30:46 PM
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.
Posted by: stanfo at Sep 15, 2008 9:40:22 PM
ZBicyclist: "Seems to me that we need to limit FDIC guarantees to very simple, transparent structures."
A customer's deposit (a liability on the bank's books) is quite simple and very transparent; heck - they can even determine exactly to whom the liability is incurred. If the Fed wants to lessen the FDIC exposure they only need to require that larger cash (and equivalents) are maintained to cover their liability (raise the reserve rate). This would most likely drive down the interest rates offered to customers since less money would be available for lending. Lower rates would lessen the desirability of FDIC insured accounts thus lessening the amount at risk to be covered by the FDIC.
The trick, then, seems to be having a rate such that the exposed amounts are manageable without actually increasing the likelihood that a bank collapses because it has insufficient deposits to cover its collateral positions. Put another way, the FDIC would want to shrink the companies without causing them to implode.
Posted by: David J at Sep 15, 2008 10:32:06 PM
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.
Posted by: Jason Armstrong at Sep 16, 2008 12:47:42 AM
Tyler, I'm with Jason. If you would care to elaborate on your premises I'd appreciate it, as otherwise this post isn't making any sense to me.
Posted by: trouc at Sep 16, 2008 1:40:28 PM
"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
Posted by: the buggy professor at Sep 16, 2008 4:15:22 PM
