Why Son Of Glass-Steagall Deserves To Be Born

By:  Forbes - John Wasik
Source: Forbes

Glass-Steagall, the New Deal law that put a solid wall between investment banking and insured deposits,  needs a rebirth.

But not because it will end the “too-big-to-fail” doctrine, which needs some even tougher legislation.  It’s time to separate the wild world of derivatives markets from traditional banking — the institutions that once made loans, held onto them and had stakes in communities.

The Depression-era law is being revived by Senators Elizabeth Warren (D-Mass.), John McCain (R-Ariz.), Maria Cantwell (D-Wash.) and Angus King (I-Maine).  The senators want to make banks smaller and more accountable.

Up until 1933, banks were free to sell and underwrite securities. When the Great Depression triggered thousands of bank failures, Congress, at the urging of President Franklin Delano Roosevelt, passed what was then called the “Banking Act of 1933.” In addition to separating investment banks from commercial banks, it set up the Federal Deposit Insurance Corporation and mandated that the Federal Reserve regulate national banks.

But in 1999, a bi-partisan group led by then-Treasury Secretary Robert Rubin, passed the repeal of Glass-Steagall in the form of the now-tainted Gramm-Leach-Bliley Act, which effectively deregulated the lion’s share of financial services. Insurers could be merged with bank holding companies (as Citi did with Travelers) and the new mega-banks were allowed to be brokers, investment bankers, real estate agents and “financial supermarkets.” Even the retailer Sears got into the game with ill-fated purchases of brokerage house Dean Witter and real estate firm Coldwell Banker (since divested).

Derivatives the Gorilla in the Room

While the financial supermarket concept proved to be a shaky business model, the explosion of derivatives trading proved to be wildly profitable for bank trading desks and is still a robust source of profits.

Unfortunately, Gramm-Leach-Bliley, along with another round of deregulation of commodities markets, provided little oversight of the derivatives markets, which imploded with the popping of the credit bubble in 2007 and failure of Bear Stearns and Lehman Brothers in 2008. As a result, huge derivatives portfolios — linked to mortgage and interest-rate securities — crashed and burned in the fall and winter of 2008-2009.  Now, a revival of Glass-Steagall hopes to insulate the insured-side of banking from the speculative side.

Since core provisions of the Glass-Steagall Act were repealed in 1999, shattering the wall dividing commercial banks and investment banks, a culture of dangerous greed and excessive risk-taking has taken root in the banking world,” said Senator John McCain. “Big Wall Street institutions should be free to engage in transactions with significant risk, but not with federally insured deposits. If enacted, the 21st Century Glass-Steagall Act would not end Too-Big-to-Fail.  But, it would rebuild the wall between commercial and investment banking that was in place for over 60 years, restore confidence in the system, and reduce risk for the American taxpayer.”

What’s at stake? Building a firewall between the monstrosity created by under-regulated derivatives trading. According to the Bank for International Settlements (BIS), last year, the size of outstanding over-the-counter derivatives was $25 trillion; $18 trillion of that was in interest-rate contracts, which are favorite vehicles for banks, which also speculate in precious metals and currencies.

Some estimates, however, place the “notional” size of the global derivatives market to be around $700 trillion.  No one knows for sure, since there’s no robust independent watchdog watching this market. If the global financial system were to see another 2008-scale blow-up — or something even larger — there wouldn’t be enough credit or government assistance to bail out the biggest players, which include most of the largest bank and non-bank holding companies in the world.

The 2010 Dodd-Frank financial reform law called for several provisions to regulate derivatives, but they’ve been slow in coming and vigorously fought by the financial services lobby. Many friends of Wall Street would love to repeal Dodd-Frank and retreat to the regulatory free-for-all before the 2008 meltdown.

In the interim, the “son” of Glass-Steagall needs to be passed. While it won’t end too-big-to-fail, it will at least sideline insured deposits — and another potential taxpayer-funded bailout — from the fast, casino world of bankers’ trading desks.