Glass-Steagall Reboot: A Cure That's Worse Than the Initial Disease

The emerging bid to restore the Glass-Steagall law has been gathering steam largely because many see it as a way to avoid future financial meltdowns. But this is a case where the supposed cure would not prevent the disease – and might very well cause unpleasant side effects.

The 1999 repeal of key sections of Glass-Steagall, which erected a wall between commercial banks and securities activities, is blamed by many for the 2008 financial collapse. But it is hard to see how. Not a single one of the biggest culprits in the financial meltdown – Lehman Brothers, Fannie Mae and Freddie Mac, AIG, Merrill or Bear Stearns – was the kind of financial hybrid that Glass-Steagall sought to prevent. Most of the problems that sprung up among financial institutions in 2008 were among pure-play institutions, primarily investment banks – whose bets weren’t being backed by insured deposits.

J.P. Morgan Chase and Bank of America were already in both the commercial and investment banking business by 2008; not only did they not collapse, they were positioned to rescue others. In fact, if Glass-Steagall had still been in place in 2008, the financial collapse would probably have come earlier and its impact would have been worse. The investment bank Bear Stearns was saved from bankruptcy by J.P. Morgan Chase – a rescue that would not have been possible if the latter was still restricted from having an investment banking arm. Similarly, Glass-Steagall would have barred Bank of America from taking over Merrill. We might have seen the impact of the Lehman collapse times three.

Moreover, if allowing banks to have both commercial and investment banking divisions threatens the security of the banking system, why was Canada almost the only country in the G7 to get through the 2008 crisis without losing a financial institution? Canada knocked down the walls between commercial and investment banking (and insurance) in the 1990s, and hasn’t required banks to shed any of their activities since. Americans who are concerned by the shrinking number of banks should look north, where for decades only five banks have competed across Canada. (And are increasingly able to compete outside the nation’s borders.)

So what are the advantages of going backward?

Separating commercial banks off doesn’t prevent them from making bad bets on mortgages; it only prevents them from making up for them through other revenue streams. Separating them doesn’t prevent them from becoming ‘too big to fail.’ If J.P. Morgan Chase was forced to split off their investment banking from commercial banking arms, both would still be huge – and the failure of either could still trigger economic turmoil. The same is true for other behemoths like Citi and Bank of America. President Trump’s biggest complaint about banking is that lenders aren’t extending enough money. (Despite the fact that commercial lending is at a record level according to the Federal Reserve). Would he be happy if splitting off investment from commercial banking caused large banks to pursue more conservative lending policies, at least during a transition period?

There is a reason that the bill to eliminate the key sections of Glass-Steagall in 1999 was signed by a Democratic president, with the support of overwhelming majorities of both parties in the Senate and the House. The parties were able to work together because majorities in both recognized a need to grow financial institutions large enough to compete on the world stage, and offer a wide range of products and services, backed by the most up-to-date technology. And there was a desire for banks of all sizes and stripes to be able to offer their customers deposit, lending, brokerage and insurance services under one roof. The need is especially acute during periods characterized by low interest rates, when shrinking spreads between banks’ borrowing costs and the rates at which they can lend requires them to diversify into other areas.

The decision to replace Glass-Steagall with Gramm-Leach-Bliley was simply a case of the law catching up with reality. Reality hasn’t changed – neither should the law.