Did Repealing Glass-Steagal Really Matter?

More than three years have passed since the financial crisis hit the United States like a speeding semi-trailer hits a Mini Cooper. Economic growth remains depressed while the unemployment rate stays elevated above 8% despite massive government spending and monetary intervention via the Federal Reserve. The world economy is experiencing a slow down not seen since the days of the Great Depression. While we are still limping our way toward recovery, humanity’s natural curiosity has demanded an explanation for why the crisis occurred to begin with. Despite the abundance of literature that has emerged on the crash of 2008, the general consensus adopted by mainstream political pundits and economists revolves around a vague declaration of “too much risky, greedy behavior on Wall Street and not enough government regulation.” Those more conservative minded, yet only a few feet outside the establishment mindset, accuse government policies encouraging mortgage lending and the gobbling up of mortgages securities on the secondary market by government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.

The Austrian economists on the other hand place blame on the Federal Reserve’s low interest policies following the dot-com crash which in turn financed an increase in mortgage lending and funneled resources into the housing bubble. They saw the crisis coming years before any other school of economic thought. Of course blame doesn’t rest solely on the Fed (as convenient as that would be) and the previous, more conventional explanations do have some merit to them. But insofar in the great debate on the true cause of the financial crisis, attributing much of the blame to the Fed hasn’t been a widely adopted view despite its overwhelming plausibility.

Meanwhile, the dogma of “more government regulation” continues to be preached by interventionists and their backers in the media as the great fix to prevent another financial disaster. One piece of legislation in particular has been focused on as providing the catalyst for rampant Wall Street speculation on such things as mortgage backed securities.

A product of the Great Depression, the Glass Steagal Act of 1933 essentially divided the practice of investment banking and underwriting of securities from commercial banking that accepted demand deposits. The relevant portions of the law were repealed (a more accurate term may be “amended”) in 1999 under President Bill Clinton with the Gramm-Leach-Bliley Act. It has been argued that deconstructing this divide allowed investment banking to merge with commercial banking under one holding company and freed up depositor’s money to be used for Wall Street’s excessive speculation en masse. One financial bursting of a bubble later, and it looks like we have our culprit.

But as is often the case, simple explanations hardly cut it when it comes to market phenomena. Billions of individuals acting heterogeneously create such complex system of transactions that incentivized behavior can manifest itself in all types of situations. In layman’s terms, though Glass-Steagal put a divide between investment and commercial banking, there is no reason to believe that it would have prevented the crisis from occurring since mortgage backed securities were acquired by the two institutions that GS was supposed to separate to begin with!

Economist Bill Woolsey explains:

Most of the commercial banks are in trouble because they hold large portfolios of mortgage backed securities. Glass-Steagall didn’t prohibit banks from investing in securities.

The investment banks are in trouble because they also hold large portfolios of mortgage-backed securities funded by very short term commercial paper. Glass-Steagall didn’t prohibit investment banks from issuing commercial paper or investing in securities.

We can imagine scenarios where the investment bank division of a combined firm convinced the commercial bank division to purchase risky securities that it had underwritten. But most commercial banks don’t have investment bank divisions, and most bought mortgage backed securities too.

The financial crisis was caused primarily by the sharp decline in value of housing and once-AAA rated mortgages backed securities that garnered profitable yields. It was the Fed-induced bubble and subsequent burst that wreaked havoc on big bank balance sheets; not the crumbling of the barrier between two institutions that virtually performed the same functions of issuing commercial paper and investing in securities. By citing GS, proponents of financial regulation put the cart before the horse by not addressing the true cause of the bubble. After all, Bear Sterns and Lehman Brothers, both of whose collapse induced the 2008 crisis, were investment banks only as noted by David Leonhardt of the New York Times.i For the amending GS theory to work, one would have expected to see both Lehman and Bear Sterns using demand deposits of their commercial banking accompaniments as collateral for risky mortgage lending. That is the narrative, is it not?

In their recent book “Engineering the Financial Crisis,” Jeffrey Friedman and Wladimir Kraus back up Leonhardt’s assertion by noting that if the GS explanation were plausible, investment banks needed to transfer their losses to their affiliated commercial banks under the same holding company. Under the provisions of Gramm-Leach-Bliley however, commercial banks are not affected by the losses of their investment banking counterparts. According to Friedman and Kraus,

“Under GLBA, a bank holding company is merely a shareholder in its affiliates; it has no liabilities for their debts, and if either an investment-bank subsidiary of a BHC (bank holding company) or the BHC itself fails, the commercial banking subsidiary is unaffected.”ii

Interestingly enough, Canada had no form of Glass-Steagal and its banking system didn’t see as intensive of a downturn as the U.S.’s. In fact, many countries don’t have a divide between commercial and investment banking. Indeed, it would seem like the invocation of Glass-Steagal is nothing more than a desperate attempt by government interventionists to find a slightly relevant regulation to grasp on to and wave around. Even if GS hadn’t been amended, former Federal Reserve chairman Alan Greenspan’s unprecedented dropping of interest rates in the early 2000’s most likely would have occurred anyway; hence setting the foundation for an unsustainable asset bubble. Government regulation, no matter how substantive and strictly enforced, will always be avoided by profit seekers forever looking for more lucrative opportunities. Even the murder and violence that plagued communist Russia didn’t prevent a black market from emerging and flourishing.

The passage of Glass-Steagall itself was wrought with issues of private interests masquerading under the veil of “in the public good.” Through the erecting of a barrier between competitors, both commercial banks and brokerage firms were prevented from having one another encroach on their respective business specialization. Even the U.S. Treasury stood to benefit as private securities were purged from commercial banks, thus eliminating a substitute investment for treasury bonds which were exempted for commercial banks to underwrite under GS according to William F. Shughart writing in the Cato Journal.iii

In the end, the repeal of Glass-Steagal played only a very minor role in the financial crisis. Both commercial banks and investment firms were buying large amounts of mortgage related paper and securities prior to the bubble burst as they appeared to be a good investment. As Mises made clear, central bank funded mirages always come to an abrupt end; leaving a broken economy and shattered dreams of wealth in their wake. The solution is never more regulation from a government already deeply infused with the industry that serves as a middle man to virtually unlimited fiat funding.

Real capitalism- private gains and losses- is the only means for the efficient use of resources in society. Those who look to politicians and overly simplistic fixes such as the Glass Steagal Act place their bets on bureaucrats over the free and open market. The difference is force and volunteerism. What they should focus on is the incredible moral hazard created by government guarantees against financial insolvency and the distortionary effect of the Federal Reserve’s artificially low interest rate policies.

Then they might actually be on to something.



i Leonhardt, David. “Washington’s Invisible Hand.” New York Times [New York] 28 Sept. 2008, MM32. Web. 15 Dec. 2011. <http://www.nytimes.com/2008/09/28/magazine/28wwln-reconsider.html?adxnnl=1&adxnnlx=1323994366-PoalT8NtaZMUEfPK7TW iA>.

ii Friedman, Jeffrey, and Wladimir Kraus. Engineering the Financial Crisis: Systematic Risk and the Failure of Regulation. Philadelphia: University of Pennsylvania Press, 2011. 35.

iii Shughart, William F. “A Public Choice Perspective of the Banking Act of 1933.” Cato Journal. 7.3 (1988): 604-606. Web. 15 Dec. 2011. <http://www.cato.org/pubs/journal/cj7n3/cj7n3-3.pdf>.

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One Response to “Did Repealing Glass-Steagal Really Matter?”

  1. policymeetsworld says:

    And, of course, we've found that mega-corporations have an interest in propping up regulatory reform… As they (or former corporate members) often influence or draft most of the legislation, they have a unique advantage. Further, regulations provide large firms security – a barrier to smaller firms keeping them honest through the stricter "regulation" of the free market.

    If my lemonade stand gained a hefty market share and the threat of competition loomed, I'd be more than willing to fork out some cash/lawyers to adhere to a few regulations than risk losing a chunk of the market to firms that threatened to present more value to the market than myself. Good read sir.

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