What Glass-Steagall 2 Gets Wrong: Everything

(Originally published here.)

new bill proposed by, among others, Senators John McCain and Elizabeth Warren, misses the point about what caused the financial crisis. The so-called Glass-Steagall 2 would do nothing to protect us from the devastation we recently experienced. Worse, it threatens to distract attention away from legitimate reform efforts.

There is a myth, popularized in part by inane television programs, that the 1933 decision to separate commercial banking and investment banking made the financial system safe and promoted decades of prosperity. According to this false narrative, the financial system was just fine until the government decided to repeal the Glass-Steagall Act of the early 1930s in 1999. This allegedly empowered unsavory securities dealers to gamble with customer deposits, or something.

People who believe this story think that the 2007 crisis would never have happened if the wall separating commercial and investment banks had remained intact. Similarly, they also believe that future crises can be prevented by enforcing a hard separation between “boring” banking (mortgages, loans to businesses, etc.) and “dangerous” banking (everything else, especially derivatives trading). This line of thinking has inspired recommendations to “ring-fence” commercial banking operations in Europe, as well as the U.S. “Volcker Rule” that is supposed to limit the ability of banks with insured depositaries to engage in proprietary trading, among other things.

All of these measures are a waste of time. As my colleague James Greiff notes, taking on deposits and lending for long periods of time is inherently risky. Iceland, Ireland and Spain all managed to generate devastating debt bubbles without the help of derivatives or complex securities. Here in the U.S., Countrywide, Washington Mutual, Wachovia and Indymac were all “boring” lenders that managed to fail spectacularly because they had made bad bets on mortgages amid a housing bubble. Nevertheless, the strange notion persists that certain financial activities are basically safe while others are dangerous by their very nature.

But don’t take my word for it: Warren herself told Andrew Ross Sorkin in an interview last year that the financial crisis would not have been prevented by Glass-Steagall. (To be fair, she also argued that the 1999 repeal sent a signal to companies and regulators that the financial industry could do whatever it wanted.)

I wouldn’t mind this Quixotic push to roll back decades of bank mergers if, as Kevin Rooseargues in New York Magazine, it were part of a long game to expand the debate about banking regulation. However, it looks more like a distraction from more useful issues, such as raising equity capital requirements and protecting consumers from products designed to take advantage of them. Some cynics even suggest that the banks are surreptitiously encouraging Warren in her misguided adventure in order to keep her away from issues where she can actually endanger their business model.

There is a much better policy program out there for those who genuinely want boring banking: separate money creation from lending. Companies that take deposits and offer payment services can only hold reserves issued by the central bank. Any company that wants to make loans has to finance all of its operations with equity raised from investors. That’s what Warren and her colleagues should suggest if they really want to make banking safer.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)


About Matthew C. Klein

I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.
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