There are people on both sides of bank regulation, those for it and those against it. Experience is probably the best guide for what needs to be regulated and how to go about regulating. The Glass-Steagall Banking Act of 1933 prohibited commercial banks, insurance companies and investment banks from doing business in each others marketplaces. In other words, a commercial bank could not also do investment banking or sell insurance, just as an insurance company or an investment bank couldn’t do commercial banking. The idea was to eliminate conflicts of interest that potentially lead to moral and ethical abuses.
Around the world there have been an incredible number of banking crises over the last hundred years, in fact, if you read This Time Is Different: Eight Centuries of Financial Folly, you can extend that time line backwards eight hundred years. The point is, any regulation that effectively fends off financial crisis is a worthwhile regulation because financial crises happen frequently and for known reasons. But what is a good regulation?
The Problem of Big Banks
Here’s how Bill Clinton’s chief economic adviser, Joseph Stiglitz, described Glass-Steagall regulation. “The Glass-Steagall Act of 1933 addressed a very real problem. Investment banks push stocks, and if a company whose stock they have pushed needs cash, it becomes very tempting to make a loan. The U.S. system worked in part because under Glass-Steagall the banks provided a source of independent judgments on the creditworthiness of businesses.” If investment banks could also offer loans then good money, in the form of a loan, could easily be thrown after a bad investment just because it benefited the bank to support the investment: in other words, self-interest. Things could become morally and ethically very confusing, very quickly during a crisis.
In 1999 after years of political influence was applied by the U.S. investment community lobbying the U.S. Congress, the Glass-Steagall Act was repealed by the Financial Services Modernization Act of 1999. Those who favored this legislation consistently pointed to the modern use of financial risk analysis as the mitigating factor that made modern finance different and immune to the problems that had driven bank failures in the 1930s. And, if you want to look at it from another angle, there had been several severe financial crises even with Glass-Steagall regulations in place, so why keep it in affect?
For example the savings and loan (S&L) crisis of the 1980s and 90s, where 747 S&L institutions failed, often after committing fraud in an attempt to stay in business occurred even with Glass-Steagall regulations in place. That financial crisis wound up costing an estimated $370 billion dollars, including $341 billion taken from taxpayers. So financial crises aren’t only about placing a divide between commercial banking and investment banking. However, other changes in both the US and global economies have come to mean the moral and ethical risks of allowing these two types of banking to be mingled, or become “full-service” banks as they are known in the industry, is more problematic than ever.
Here’s the risk, again, according to Joe Stiglitz. “When enterprises become too big, and interconnections too tight, there is a risk that the quality of economic decisions deteriorates, and the ‘too big to fail’ problem rears its ugly head. Expecting to be bailed out of trouble, managers become emboldened to take risks they might otherwise shun. In the Great Depression, when many banks were on the ropes, it was, in effect, the public that bore the risk, while the banks got the reward. When banks failed, the taxpayers paid the price through publicly funded bailouts.” It all sounds so familiar having gone through the same process just five years ago in 2009.
What If This Time Isn’t Different?
But here’s why its a different problem this last time around and why it continues to be a problem. The size of the banks are now much larger than they ever were before. Banking used to be a local and regional business. Banks were responsible for the loans they made and didn’t want to lend to people too far away from their location, where they new the local economy. But over the last forty years that has changed. Global business has become such a prominent part of the US economy and in particular, during that time, the oil industry has pulled the US economy into global transactions.
The scale of projects that global companies undertake require access to bigger loans. Oil companies get into extremely big projects that are time sensitive and need financing put together quickly and massively. In order to have reliable access to this type of financing the oil companies have encouraged and supported banks in growing larger. Big oil companies, like Exxon, need big banks like Citibank and they need them everywhere and anywhere around the globe. Projects often require hundreds of billions of dollars of financing.
With these big banks the too big to fail problem becomes even more threatening. Banks are now so large that if they fail the global economy will feel the effects. Knowing that nobody wants to be at the helm when the economy goes down the tubes, bankers are all the more likely to take ill-considered risks and engage the too big to fail option. The 2008 mortgage crisis is a prime example. The big New York banks gorged themselves on toxic residential mortgage assets knowing that most of those assets were derivatives with very shaky risk constructions. RISK… remember the new risk capacity was a strong reason why regulations were dropped. When Lehman Brothers failed in September of 2008 it brought all these financial frailties to light. The only redeeming feature of the 2008 collapse was that the underlying US economy was relatively healthy. Growing with the digital companies of Silicon Valley. The US economy experienced a low inflation rate when the 2008 crisis hit. That won’t always be the case.
You Could Check The Numbers
Consumer prices rise and fall on a regular long wave pattern. From 1945 to 1971 the Consumer Price Index (CPI) was low and stable. During the 1970s and through the mid 1990s inflation took hold as consumer prices moved considerably higher. From 1995 until today inflation has been at bay and the CPI is low and stable. You can check these statistics at the Minneapolis Federal Reserve Bank’s publication on historical inflation statistics. But what happens when the CPI changes and inflation takes hold again? Everyone would prefer that not to happen, but it comes about with regularity approximately every twenty-five years. That means somewhere around the year 2020 it would not be surprising to see inflation once again become an issue in the American economy. Will that happen and if so how?
In the book I mentioned earlier, This Time Is Different, the authors point out one of the primary features of all financial crises is confidence. Public confidence in the financial management of markets is significant. They say, “Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public’s expectation of future events, that makes it so difficult to predict the timing of debt crises.” They further say, “Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability.”
The US economy’s lack of Glass-Steagall type regulation to separate commercial and investment banking played a powerful role in the economic collapse of 2008. There is no regulation in place right now that would completely preclude the same type of banking arrangements, as were in place in 2008, to once again bring about another collapse. The recent passage of the Volcker Rule, which reins in high-risk trading, banning the largest banks from trading for their own profit, has significant loop-holes, allowing them to continue making risky trades. Then too, there is the matter of leverage ratios, which remains unregulated and allows large banks to hold less capital in-house to protect against liquidity problems when their own risky investments go bad. Bankers take ill-considered risks when there are huge financial rewards in front of them, and all the fancy risk assessment programs in the world can’t do anything about it. And thus far, regulators haven’t done enough about it.
The next bubble, whether its a replay of the mortgage collapse of 2008 or it occurs in another area of the economy, is just as likely to involve bad investments on a huge scale by big banks and investment houses. But if the consumer price index is closer to shifting upward, the underlying economy is far less likely to support such a large financial shock. The public is likely to sour over any financial misdeeds and challenge public confidence in the whole economic system. These possibilities seem more significant from the vantage point of our post 2008 line of sight.