There has been a lot of talk lately about the repeal of
Glass-Steagall in the 1990's and the potential that such a move
contributed greatly to the financial crisis. Glass-Steagall,
originally passed in 1933, had many parts to it but it is most
widely known to have disallowed commercial banks that gathered
customer deposits and gave out loans from also being investment
banks that would underwrite securities and trade for their own
The logic of Glass-Steagall makes sense: banks should not use
depositor or government capital to fund internal hedge funds.
Should the enormous risks the trading desks take turn sour, it puts
customers' deposits in jeopardy and reduces the amount of lending
the firm can do. Not to mention the fact that cheap government
funding is given to banks to boost lending and the economy, not to
generate trading profits for the firm's partners.
Despite the soundness of the law, those who maintain that the
repeal of Glass-Steagall was a leading contributor to the financial
crisis are off base. Why? Because most of the casualties of the
financial crisis were not banks at the time. Off the top of my head
I can name AIG (
), Fannie Mae (
), Freddie Mac (
), Lehman Brothers, Bear Stearns, and Merrill Lynch.
None of those firms were commercial banks but they lost the most
money. Those losses came from poor mortgage underwriting, poor
insurance underwriting and extreme leverage ratios of up to
40-to-1. More effective government regulation surely could have
helped prevent such monumental downfalls (minimum underwriting
standards and leverage limits to name a couple), but a combination
business model of commercial and investment banking was not the
culprit by any stretch of the imagination.
Now there were commercial banks that failed or nearly did during
the recent crisis. Wachovia and Citigroup (
) are the two big ones. But again, Glass-Steagall would not have
prevented this. Citigroup was hampered by its leverage and
significant holdings in mortgage backed securities, CDOs and SIVs.
Wachovia failed after it acquired a California-based mortgage
lender that pioneered interest-only, pick-a-payment and option ARM
mortgage products. Such poor, undocumented, mortgage underwriting
doomed them from the start, not investment banking (Wachovia did
little, if any).
I am all for better regulation of the financial services sector,
but many of the ideas floating around do not really address the
core issues the industry faces. Not only that, existing regulators
and laws easily allow for better regulation, without further
changes, even though modern products such as credit default swaps
and futures contracts clearly need to be regulated going
How to Reform the Financial System: Our 10 Point