Volcker Is Right About Glass-Steagall

William Rees-Mogg Times of London December 21, 2009

How does one give a wake-up call to the Masters of the Universe? Very little progress has been made in the reform of banking regulation, even after the worst banking panic for 80 years. In Britain we will have to wait for the general election before we get a new government, capable of taking new decisions.

In the United States, they already have a new government, but it has been involved in other pressing issues including healthcare reform, the Copenhagen summit and the Afghan war. The Basel Committee on Banking Supervision has produced a set of proposals but there is certainly no global consensus on what needs to be done. The bankers continue to award themselves large bonuses.

There is however a very interesting debate taking place in the United States. Paul Volcker, who is the head of President Obama’s economic recovery advisory board, has supported Senator John McCain’s proposal for a return to the Glass-Steagall banking regulation. Under the Glass-Steagall banking act of 1933 the United States based its banking regulation on a statutory separation between investment banks and commercial banks.

Britain did not have the same legislation, but we did have a small group of large clearing banks, which carried out retail banking functions, but left investment banking to the merchant banks. In the United States the Glass-Steagall Act was repealed in 1999; in Britain the Big Bang in the early 1980s led to the clearing banks moving into investment banking functions. If the United States does decide to return to the system that made US banks stick to their core business, it seems likely that Britain would follow, though there would be considerable resistance.

Mr Volcker is an historic figure in modern finance. He was the Chairman of the Federal Reserve Board from 1979 to 1987. In that period he brought the global inflation of the 1970s and 1980s under control through his tough adoption of high interest rates.

At the time he was widely praised as the man who saved the world economy from hyperinflation. He avoided the mistakes of his successor, Alan Greenspan, who did not have the determination to counter-attack financial bubbles in their early stages. Mr Volcker has been right before, and everyone knows that he could be right again.

Senator McCain, the Senator from Arkansas, remains a maverick figure despite having been the Republican candidate for president. Last Wednesday he introduced a Bill to restore the Glass-Steagall act, with its separation of commercial and investment banking.

The division laid down in the 1933 banking act would have prevented the purchase by commercial banks of some of the speculative instruments that triggered the banking panic of 2007 and undermined leading banks throughout the world.

It would not have been legal for US commercial banks to buy for their own account the “collateralised debt obligations” or the “credit default swaps”, which led to such large losses. This rule would have protected depositors and bank shareholders, as well as the US and UK governments. The ordinary customer of a commercial bank wants to have security above everything else.

As a result of departures from the traditional banking business, the credit of many global banks has been undermined and many of them have had to be rescued by the state. Both Mr Volcker and Senator McCain want to return to the Glass-Steagall rules that would prevent the mixing of two very different types of banking business. A return to Glass-Steagall would leave speculation to the speculators, and protect the ordinary customers of ordinary banks.

Mr Volcker spoke last week to a conference of Wall Street executives. He opened his speech with the words: “Wake up, gentleman . . . I can only say that your response is inadequate. I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the global economy — just one shred.”

The opposition to a return to the Glass-Steagall rules in the United States comes mainly from Wall Street, but it is also to be found in Congress. In Wall Street, as in the City of London, much of the opposition is obviously self-interested. Bankers do not want regulations that would have the effect of reducing their bonuses, any more than they want to pay new taxes on the bonuses.

Ordinary commercial banking is a relatively straightforward business: because it is not speculative, it makes modest, but usually regular profits. Investment banking is more complex, and much more risky. When the speculations are successful, the bonuses can be huge. When the speculations go wrong, the government is called on to save the bank, but the depositor and the shareholder will also be at risk.

There is a long history of banking panics. There has to be an expectation that they will continue to occur in the future. After a long spell when panics have been minor or local, it is natural for people to forget that they can come like a tsunami, and suddenly overwhelm ordinary people and ordinary businesses.

Investment bankers in the period before 2007 were taking far greater risks than they — let alone their customers — ever realised, and they were cashing in on their successes without thought of the likelihood of failure.

Paul Volcker’s role in financial history is that he successfully stabilised the greatest inflation since the end of the Second World War. Now the great stabiliser tells us that we need to stabilise our banking, whether the bankers want it or not. I would support his policy to reintroduce banking regulation, in Britain as well as in the United States. “Wake up, gentleman. Your response is inadequate.”

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William Rees-Mogg

William Rees-Mogg has had a distinguished career with The Times and The Sunday Times. He was Deputy Editor of The Sunday Times before becoming Editor of The Times in 1967, a position he held until 1981. He was made a life peer in 1988. Since 1992 he has been a columnist for The Times, writing on a variety of issues. He has also been chairman of the Broadcast Standards Council and British Arts Council

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