repealing of Glass Steagall a Mistake

I believe that repealing Glass-Steagall was a mistake. There are several reasons for this, not the least of which is the critical, fundamental difference between investment banking and retail or commercial banking. But the protections that Glass-Steagall put into place guarded against issues that were relevant in the 1930s but never stopped being relevant. The financial crisis of 2007-2009 is strong evidence that the need to protect against commercial banking volatility is more important that the need to allow investment banks to \\"innovate\\". This paper will illustrate the case that repealing Glass-Steagall was a mistake.

It is important to understand the environment in which Glass-Steagall was passed in order to understand the merits of the Act, and evaluate whether it stands the test of time and should have been left in place. Prior to Glass-Steagall, the US economy was subject to a multitude of economic shocks. Under conditions of laissez-faire management, the economy went through a number of boom-bust cycles. Dating as far back as the Dutch tulip boom in the 17th century, to booms associated with the opening of new markets (i.e. South Seas), finding new deposits of gold, to railroads, economic activity followed boom-bust cycles (Bordo, 2003). Marx predicted that these cycles would continue if capitalism were to be left unfettered.

Following the latest bust, the stock market crash of 1929, the Glass-Steagall Act was passed in order to restructure the banking system (Heakall, 2015). Setting up a structure for the US economy was a work in progress – indeed at that time this was a work in progress for many industrialized nations. Some of the other, prior, steps had been the creation of Federal Reserve and the introduction of monopoly protections under the Clayton Act. The objective of these different elements was to bring about some semblance of control over capitalist activities, under the recognition that when busts occurred, many people suffered, including many who were not a part of the boom in the first place. The Great Depression was another recognition of this fact as millions were thrown out of work with no social protections.

Glass-Steagall therefore did a couple of things, owing to the separation of investment and commercial banking. By putting strict limits on the amount of profit banks in either sector could earn in the other, the Act focused each bank\\'s attention on its core business. By doing so, it recognized the fundamental reality that investment and commercial banking are very different from one another.

Commercial banking is an inherently stable business. Consumers need to have commercial banks that are reliable in terms of holding savings and borrowing to buy property. Small business relies on these banks as well, for loans and start up financing. When commercial banks are stable, this creates an atmosphere of confidence in the economy. The reality is that when they are unstable, people are more hesitant to deposit money, if they think that there is a chance they could lose that money. With no deposits, banks cannot lend, and that means no mortgages, car loans, or small business loans, and that would be incredibly detrimental to the economy. One of the key objectives of Glass-Steagall was to ensure that there would be stability in the economy via stability in the commercial banking system.

Investment banks, of course, have an entirely different business model. They take companies public, and work on mergers and acquisitions. As such, investment banks not only work on bigger deals, but they take on inherently more risk in their businesses. Over time, investment banks have become incredibly creative when it comes to structuring deals and investment products alike, something that the repeal of Glass-Steagall didn\\'t take into account. While there were still limitations, sometimes fairly strict, on the activities of investment banks, they are clearly more volatile by the nature of their work, relying on large deals rather than a large amount of smaller deals. Commercial banks are inherently better diversified than investment banks. The high degree of both volatility and complexity in investment banking makes it a poor match for commercial banking.

Following Glass-Steagall, there were few economic shocks. There were surely other factors involved, but not until the oil price shocks of the 1970s were there strong shocks to the US economy – for a period over 25 years there was stability. The reality is that the distinction between these two types of banking compartmentalized risk in an industry that knew how to handle it. Further, the general public was never really on the hook for the activities of investment banks.

This latter factor became an issue when the repeal of Glass-Steagall was on the table, because there was clear evidence from the late 1980s of what would happen if the separation between investment and commercial banking occurred. The savings & loan crisis brought the phrase \\"too big to fail\\" into the political lexicon, meaning that retail financial operations needed to be protected by government, because the economy was so dependent on them that if they were to fail, the entire economy would suffer, and suffer more than the cost of the bailout. The US economy could absorb the savings & loan body blow, but the repeal of Glass-Steagall promises something much, much bigger. Instead of bailing out a few hundred small institutions, there would come a day when the government needed to bail out massive investment banks, or worse yet massive retail financial institutions. This would come at taxpayer expenses, which would have significant impacts down the line for interest rates, the national debt, and other macroeconomic implications that could stretch out for years.

So Glass-Steagall instituted structure and order, and in particular segregated risky banking from non-risky, and repeal of Glass-Steagall not only promises to introduce a higher level of risk to commercial banking, but to put the taxpayers on the hook for the downside of that risk.

Glass-Steagall was repealed in 1999 via the Gramm-Leach-Billey Act. Following the repeal a couple of things happened. First, investments and mergers within the industry led to the creation of companies that, with both investment and commercial banking activities, were too big to fail. This was predicted ahead of time and was a logical outcome – commercial banking needs stability, and bigger commercial banks would indeed to \\"too big to fail\\" (Crawford, 2011). In this case, it was largely commercial banks increasing their investment banking activities. Such banks would not have had the requisite experience with risk to execute investment banking effectively. The mortgage-backed security crisis is just one example of this – creating securities with convoluted structures and risk profiles, or investing in these securities as a means of earning superior returns, but in doing so exposing themselves to risk to which they never would otherwise have been exposed. Banks in Canada and Australia, for example, with tighter controls on such activities, were not heavily invested in these toxic assets and those countries had stable banking systems through the crisis, where banks in the US and in many European countries did not.

Furthermore, the taxpayers were on the hook for a lot of the damage; too big to fail meant that many banks had to be bailed out to maintain a semblance of stability and consumer confidence in the banking system during the crisis. TARP and other acts cost taxpayers billions, and did not prevent crisis, merely allowed that the crisis would not completely undermine the entire US economy. Yet, full economic recovery took years, and the US is still below where it otherwise would have been had the crisis not occurred.