Time for a new Glass-Steagall?

Does anyone else find that all of the talk about breaking up the too-bog-to-fail discussions is somewhat akin to Mark Twain’s observation about weather conversation? Everyone talks about breaking up the giant financial institutions, but few seem keen on starting the project.  A bipartisan group of Senators — well, some Democrats and John McCain, anyway — have proposed reinstating a form of Glass-Steagall, the Depression-era law that blocked banks from higher-end investment activities until 1999.  That would force the biggest institutions to break up, but will the coalition pushing it ruin its chances?

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Progressive Massachusetts Democrat [Elizabeth] Warren, a Banking Committee member and leading crusader for financial reform, introduced a bill Thursday to revive Glass-Steagall, the law passed in 1933 that separated commercial banking and investment banking. Glass-Steagall was repealed in 1999 by President Clinton, but progressives and some Republicans favor its reinstatement.

Warren’s bill would separate banks that provide checking and savings accounts from investment banking firms and hedge funds in an attempt to safeguard against another financial crisis. Conservatives are already lining up to oppose the bill.

“If Elizabeth Warren is leading the way on this bill, considering her views on [banking], then it’s probably not going to be a bill that conservatives will support in any way,” Richard Manning of Americans for Limited Government told The Daily Caller.

Warren’s bill is co-sponsored by McCain, Democratic Washington Sen. Maria Cantwell, and freshman Sen. Angus King, a left-leaning first-year independent from Maine who caucuses with the Democratic Party.

“Sens Warren and McCain introduce a bill to resurrect Glass-Steagall. Applause,” tweeted former Clinton administration Labor Secretary Robert Reich, a Berkeley professor and member of President Obama’s economic transition advisory board in 2008.

In principle, anyway, this would tend to improve the situation, but not solve it entirely.  The Bush and Obama administrations rescued the big financial institutions — at least those they liked — because a crash would have wiped out not just the investment-banking sector but most or all of the entire industry.  That happened in part because of the repeal of Glass-Steagall in 1999, and in part from consolidation within the financial services industry.

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But the root cause of the crash wasn’t consolidation or even bad bets.  It was the government intervention into the mortgage markets in order to drive up housing demand that created the distortion in the first place.  Democrats and Republicans in Congress, and the Clinton and Bush administrations, all wanted to promote home ownership for their own political ends.  That push got so out of hand that the Bush administration belatedly and weakly attempted to restrain Congress when the market got too irrational.  Congress allowed Fannie Mae and Freddie Mac to infect the bond markets with junk mortgage-backed securities.  Even Glass-Steagall wouldn’t have rescued the investment sector from that crisis.

In other words, this isn’t a panacea, nor would it break up the big institutions on the financial-investment side on its own, where the risk really lies.  It would separate everyday banking functions from any folly in the investment sector, but it’s not all that clear that this would prevent the need for a bank bailout if the same set of circumstances arose, although the scale might be smaller – depending on how invested the banks are in the financial institutions. What’s needed is not just Glass-Steagall but also a rollback of consolidation in both banks and investment houses.

Still, as an incremental approach, this might be a good idea.  It’s difficult to see how to break up the too-big-to-fail institutions without Glass-Steagall at some point.  Bloomberg’s Simon Johnson offers five reasons that Congress should take up the proposal as an incremental reform:

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1) The bill would actually help small banks, because it would force the taxpayer-subsidized megabanks and related financial companies to break up. Anything that tilts the playing field back toward smaller financial institutions is good for the small business sector.

2) The simplifying intent of the 21st century Glass-Steagall Act is complementary to other serious reform efforts underway, including plans for the “resolution,” or managed liquidation, of any financial firm that fails. The main problem for resolution is that the largest firms are incredibly complex, and the impact of any failure could reach far and wide in unpredictable way. Making the biggest financial firms simpler would also dovetail nicely with the legislation proposed earlier this year, by Senator Sherrod Brown, Democrat of Ohio, and Senator David Vitter, Republican of Louisiana, that would significantly increase capital requirements for the very largest banks.

3) Proponents of big banks will claim that the breakdown of the original Glass-Steagall Act (which separated commercial and investment banking) did not contribute to the crisis of 2007-08. That view is so wrong that James Kwak and I wrote an entire book debunking it. More important, what did or did not happen in the run-up to 2007 is largely irrelevant. The doctrine of “too big to fail” has been with us for some time, but it was fully established by the policy response that followed the collapse of Lehman Brothers.

4) As the preamble to the 21st century Glass-Steagall Act points out, it represents a convergence with European reform thinking, as seen in the Vickers Report (for the U.K.) and the Liikanen Report (for Europe more broadly). We need structural change in banking in all major financial centers if large-scale cross-border banking is to become safer and better run.

5) The Treasury Department is not going to welcome the legislation — in fact, it may assist in mobilizing opposition. At this stage, this is an advantage, not a problem. Treasury has a severe case of reform fatigue. It’s time for someone else to carry the ball.

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Conservatives are already mobilizing to oppose it, probably more because of the involvement of Warren and suspicions about her motives on anything to do with the financial sector.  Those aren’t necessarily bad instincts to have.  However, we’re five years out from the crash, and we still haven’t done anything about Too Big To Fail, leaving taxpayers vulnerable to another massive bailout if the worst happens.  Maybe this isn’t a bad first step to take — or at least take seriously enough to consider.  We have to start somewhere, after all.

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