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A Little Learning: On lessons already learned (and unlearned)

Published: April 30, 2010
Section: Opinions


Having slogged through health care, and with immigration and climate change next up on the agenda, the United States Congress currently finds itself embroiled in the debate over financial regulation. Virtually everyone agrees that something must be done; unfortunately, exactly what that something is remains contested. For the moment the Democrats are quite happy to play politics with the issue, forcing Republican senators to make unpopular votes against their regulatory legislation.

In June of last year President Obama put forth a plan for financial regulatory reform, two aspects of which immediately drew fire: giving the Federal Reserve greater authority to supervise financial institutions whose size poses a systemic risk to the economy, and the creation of a new regulatory arm, the Consumer Financial Protection Agency (CFPA).

With its plain, workmanlike title, the new CFPA quickly came under attack for proposing to protect financial consumers. Banks naturally claim that such an agency would unduly hamper consumer choice: after all, who isn’t a fan of predatory lending.

Congress, in a rare moment of wisdom, chose to act on the president’s suggestions, and on Dec. 11 the House of Representatives passed a regulatory bill by a vote of 223 to 202. The Senate couldn’t quite manage that running start. Christopher Dodd of Connecticut introduced a bill that would limit the involvement of banks in the regulatory process as well as examine the markets for the possibility of systemic risk. The bill would also give the Federal Reserve the job of monitoring the largest banks, those worth $50 billion or more.

The most radical (just how radical you’ll see in a moment) measure came from Senator Blanche Lincoln of Arkansas. Lincoln’s proposal would require banks to divest themselves (to “spin off”) their derivatives trading units (derivatives, and their sub-category Credit Default Swaps, being oft fingered as a principle cause of the financial meltdown). Banks would be given a choice: give up derivatives trading or lose their access to federal deposit insurance (the famous “Federal Deposit Insurance Corporation (FDIC) insured” in every bank advertisement).

Barring consumer banks from an entire sector of the market— surely that’s a radical step, no? Only if you’ve never heard of something called the Glass-Steagall Act. One of the first pieces of New Deal legislation passed in 1933, the act created the FDIC and expanded the Federal Reserve’s power to loan troubled banks money. But the most important part of the act was to separate commercial and investment banking. Banks then operating had to decide if they wanted to continue as commercial (read retail) banks or investment banks financing corporations.

Ever wonder why there are both J.P. Morgan Chase and Morgan Stanley? Back in 1933 J.P. Morgan and Company was given the choice of becoming a commercial or an investment bank: they decided to remain a commercial bank (which later merged with Chase Manhattan Bank), while they separated their investment functions into the brokerage house of Morgan Stanley (Harold Stanley being one of the founding partners).

In time the regulatory regime imposed by Glass-Steagall broke down, until then the separation of commercial and investment banking was repealed entirely by the Gramm-Leach-Bliley Act of 1999. Commercial banks, investment banks, securities firms and insurance companies were allowed to consolidate for the first time since the Great Depression. While not necessarily responsible for it, this law certainly influenced the wave of consolidation seen in the banking industry in the last decade, and hence the creation of more financial companies considered “too big to fail.”

The basic argument against uniting commercial and investment banks remains just as it was in 1933: that commercial banks —the banks where you and I put our money—have an incentive to be conservative in their lending practices, while investment banks have an incentive to be liberal in such practices. The large risks inherent in securities lending can threaten the deposits of a single, united bank, forcing the government to come in and secure the bank or risk paying out huge sums in deposit insurance. Sound familiar? It’s called a bailout.

Given this history, it becomes rather hard to see Blanche Lincoln’s proposal as very radical at all. Indeed, in December Republican John McCain of Arizona and Democrat Maria Cantwell of Washington State proposed reenacting those parts of Glass-Steagall repealed in 1999. One version of this—limiting liabilities in various areas—has been proposed by former Federal Reserve chairman PauOnl Volker, and included by President Obama in his proposal for reform.

The banking industry is naturally opposed. After spending years trying to get Glass-Steagall repealed, the prospect of its re-imposition has prompted near unanimous resistance. While hardly going so far as to break up the fundamental units of banking as Glass-Steagall did, Senator Lincoln’s proposal to spin off derivatives deserves serious consideration.

Last week the measure passed the Agriculture Committee by a vote of 13 to eight. It should be enacted into law. Surely we have enough evidence to show what happens when you join massive firms and huge risks.

Eventually someone makes a bad bet.