Wednesday, January 6, 2016

Is Bernie Sanders Right About Glass Steagall?

By Roy C. Smith

Yesterday Sen. Bernie Sanders announced a seven-point plan to rein in Wall Street greed once and for all by “breaking up the big banks and re-establishing firewalls that separate risk-taking from traditional banking.” Sanders is a populist, so of course his plan has a populist ring to it; but, nevertheless the plan ought to be analyzed on the merits.

The key feature of the plan is to re-impose the 1933 Glass Steagall Act that separated traditional banking from the securities business, and which Congress repealed in 1999.  Much resisted by Wall Street when it was passed, the law changed the competitive environment of the US financial system, but led to fifty years of stability in banking and the development of robust capital markets that enabled companies to obtain large amounts of financing for longer term, riskier projects. By 1983, the US capital markets were the envy of the world and efforts to import US financial market technology and knowhow to Europe and Japan were well underway.

However, a global banking crisis began in 1984 with the Federal Reserve’s takeover of Continental Illinois Bank, which failed because of poor credit risk management and the consequent inability to roll over maturing deposits from large financial institutions. Other large banks had similar problems, so the crisis ultimately spread throughout the US, and then migrated to Europe and Japan, where, like the US, a Glass Steagall-type of law was also in place. Many banks had to be rescued by government funds during the fifteen years or so that the crisis endured. However, the suppression of bank lending imposed by government rescuers further shifted financial activity to capital markets, where corporate needs during the relatively high growth years of the 1980s and 1990s were fully met.

After the crisis, the banks realized that much of their business with large corporations had been disintermediated to capital markets where short term working capital could be raised more cheaply in commercial paper, medium tern notes and bond markets in the US and the Euromarket. The banks complained that their European competitors could participate fully in capital markets, but they were losing business because they could not. Bank loans, too, had become tradable in markets and had, partly through developments in derivatives technology and capacity, become integrated into fixed-income securities markets. Further, they argued, the Basel Accord that set a minimum requirement for risk-adjusted capital adequacy had been agreed, so another crisis was unlikely. It took several years to build support, but Glass Steagall was repealed in 1999.

After the crisis in 2008, governments around the world once again poured funds into large banks to prevent their failure and domino-like contagion of the problem throughout the global financial system.  The rescues involved several trillions of dollars (mainly expended by central banks through lender-of-last resort and market support activities) but stabilized the global financial system within a few months. 

Three observations of this history are worth making.

One – Glass Steagall did not prevent the banking crisis in the US and Japan in the 1980s and 1990s. Nor did the Basel Accord prevent the crisis of 2008.  Regulations don’t always accomplish what they intend.

Two – the crises involved many performance-oriented banks all around the world that were following similar business strategies in competition with each other (though under an extensive regulatory regime). These strategies focused on enabling companies and financial institutions to take on risk and projects necessary for growth. It was not just because of unlawful conduct, greed or incompetence that the crises occurred; it was much more a matter of systemic market failure. 

Three – government intervention was the only way that the financial system could be saved from total collapse with much more severe effects on the real economy than actually occurred. Too-Big-to-Fail policies were indeed necessary; the government was the only source of funds to act as a lender of last resort under such circumstances. Taxpayers actually made a considerable return on their investment in such programs as TARP and stabilization efforts by the Federal Reserve when these positions were unwound.

After the 2008 crisis when Congress was debating the Dodd-Frank Wall Street Reform and Consumer Protection Act (passed in 2010), a re-imposition of Glass Steagall was considered.  The arguments for it were that banks had become too big, clumsy and herd-like (and greedy) to manage market risk well enough to avoid the possibility of a future failure. The easiest way to reduce this risk would be to make banks give up capital market activities.  There was merit to the argument (that also applied in 1999) but banks strongly resisted a one-size-fits-all policy that would permanently bar banks from capital markets where three-fourths of the capital raised by large corporations occurred. They also objected to a policy that would affect them but not their foreign bank, or US non-bank, competitors.

Another argument was the extent to which bank lending had become integrated with securities markets, making activities difficult and expensive to separate, monitor, and enforce.

In the end, Dodd-Frank did not separate banking and securities businesses, or force banks to reduce themselves to smaller sized entities, but it did many other things that give much more power to regulators to control the financial system, and limit risk taking by banks. Dodd-Frank claims that it has eliminated Too-Big-to-Fail situations in the future, but it attempts to do so not by restricting their bigness (except in terms of a maximum market share of US bank deposits), but by restricting the amount of risk of failure than the banks can take on.

Dodd-Franks defines “systemically important” banks as those with assets greater than $50 billion (about 40 US banks), which are to be subject to much tighter regulations than non-systemic banks. It also empowers the government to designate “systemically important non-banks” (the so-called “shadow banks”) and to regulate these the same as the large banks (four non-banks have been designated as systemically important so far). 

Dodd-Frank has many other provisions, including annual stress tests necessary to pay dividends, regulation of proprietary trading (“speculation,” which Bernie wants to tax), derivatives markets, executive compensation, rating agencies (Bernie wants to force them to become non-profit organizations), and consumer protection.

The irony of all this is that the weight on the big banks of Dodd-Frank, Basel III (a tough upgrade of the original Basel Accord), and various new national banking rules around the world, has made it very difficult for banks to comply with all the new regulations and still make a return on investment greater than their cost of equity capital.  Almost all of the major banks have failed to produce a net positive return on equity since 2009, so all are required to alter their basic business models to enable improved returns.

Accordingly all banks have their eyes on one of their own, Well Fargo, which has sailed through the regulatory changes relatively unscathed.  Wells, essentially a retail and consumer bank, never had a very extensive capital markets activity beyond what was needed to service its mainly small and mid-sized corporate clientele. Today it is the world’s largest bank by market capitalization, trades at 1.7 times its book value (the rest trade at an average of about 1.0x), and generates 5% net return on equity (after subtracting the cost of equity).

For big US banks like JP Morgan Chase, Citigroup and Bank of America, the best approach to modifying their business models as a result of regulatory changes may be to spin off to shareholders their riskier and more capital intense investment banking units. Doing so would improve shareholder returns, make regulators happier and enable their investors to participate in two different, but separate, business models. Doing so would also, de facto, break up these banks as if Glass Steagall had been restored.

Bernie Sanders probably has the right idea about what would be good for the banks and everyone else. But, restoring Glass Steagall is not necessary because Dodd Frank imposes so much regulatory weight on them that their best way forward may be to break themselves up.

But, the banks haven’t done so yet, and don’t seem to be inclined to do so.

Maybe things will be different by the time of the election, or by 2017 when the new administration will be pulling its legislative agenda together. But, if Bernie should somehow pull off a win, then he still has to face a Republican House or Representatives (and maybe a Republican Senate to), which will make his financial reform package tough (probably impossible) to pass.

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