Glass-Steagall Act To Return?

After the revival of the uptick rule that we saw being mooted yesterday, the next piece of Depression-era legislation to get bandied around is a reinstating of the Glass-Steagall Act. No doubt we’ll soon have Vikram Pandit wearing a trilby and Tim Geithner announcing that he expects the recession to end in “months numbering a score and ten”, while we queue up for soup kitchens and Busby Berkeley revivals.

The Glass-Steagall Act was passed in 1933, and split apart investment banking from commercial banking, so that the speculations of investment bankers wouldn’t harm the public’s commercial banks if they went wrong. And so the American banking system stayed until 1999, when Phil Gramm introduced a repeal of the Act that was eventually passed with an overwhelming majority in the Senate.

The repeal meant that large commercial banks like Citigroup and Bank Of America could indulge in investment banking, leading to a more widespread use of instruments so complex even the heads of banks couldn’t understand them, like structured investment vehicles. People started defaulting on the mortgages that these investment strategies afforded them, and because they were so widespread after the repeal of Glass-Steagall, the world went plughole-wards.

Hence Paul Krugman accusing Phil Gramm of being the chief architect of the financial crisis behind Alan Greenspan (though it should be noted that Democrat heavyweights including Kerry, Biden and Daschle all voted in favour, and Larry Summers supported it too), and the momentum for reinstating the act is gathering. Paul Volcker, who heads Obama’s Economic Recovery Board, said last week: “Maybe we ought to have a kind of two-tier financial system”. Sheila Bair, one-time possible Treasury Secretary and head of the FDIC, said that the size of banks should be limited so that they couldn’t get so big that they need to be bailed out by the taxpayer, hinting support for the splitting of investment and commercial banking, which would break down megabanks into smaller separate parts.

Even Guy Hands, bane of Lily Allen’s existence, expressed support for the act in his annual review: “The Glass-Steagall Act was a sensible reaction to the 1930s depression, and it is a tragedy that the hubris of bankers, regulators and politicians resulted in its repeal. It needs to be reinstated globally as soon as possible”. And Barack Obama, in a March 2008 speech, suggested his discomfort with the 1999 repeal: “by the time the Glass-Steagall Act was repealed in 1999, the $300 million lobbying effort that drove deregulation was more about facilitating mergers than creating an efficient regulatory framework”.

In the UK too, there’s been banter about installing a similar system, something we’ve never had before. Gordon Brown ruled it out last month, saying: “We do not envisage, as some have advocated, a rigid divide in future between “narrow banking” – retail and corporate deposit taking – and investment banking and trading conducted at an international level”. But George Osbourne said it’s “something worth considering”, and Sir James Sassoon, a former managing director at the Treasury, said the idea “deserves more thorough scrutiny”, but would need to be matched with other new regulatory measures.

So should it just be brought back in unchanged? The FT’s John Gapper doesn’t think so. “Even if it were possible to split bank lending from securities underwriting…it is useful to have banks, to buy insolvent investment banks”. And the newspaper’s Lex column opined yesterday: “A new Glass-Steagall would be no panacea”, pointing out that purely commercial banks like Northern Rock and Germany’s IKB were the first to go down during this crisis, and that “the real problem lies in the fuzzy relationship between banks and the opaque world of the shadow financial system”, not in banks with both commercial and investment interests. And don’t underestimate the lobbying power that Obama mentioned – as former Bear Stearns chief Alan Greenberg said, with colossal understatement, a reinstatement of the act “will run into a little bit of opposition from the same people who fought so hard for the death of Glass- Steagall”.

But Gapper does suggest a modulation of Glass-Steagall, to reduce risks, reduce size (as Bair suggested was necessary), and prevent conflicts of interest. What it will end up looking like will be the result of a long battle between House, Senate, executive and lobbyist, but we can definitely be sure that money, created through complex and risky means, is something that will stay in investment banking for a long time, and will be very hard to breed out. Let’s try and keep it away from the rest of us somehow.

Posted by Ben Beaumont-Thomas in Hot Money | March 12, 2009 12:46PM |