Doctors Warren and McCain: Screwing Up the Diagnosis and the Prescription
Today Elizabeth Warren and John McCain unveiled the “21st Century Glass-Steagall Act” that would restore the separation of investment banking and commercial banking, along with a few new restrictions on the things commercial banks with access to deposit insurance can invest in.
I really don’t get the nostalgia for Glass-Steagall. I really don’t. What’s next? High Button Shoes for the 21st Century? Radio tubes for the 21st Century?
Smarter people than McCain and Warren (a bar that a snail could jump, I admit) have pumped for the restoration of Glass-Steagall. Luigi Zingales is a prominent example. I expressed my criticisms of Zingales’s advocacy of Glass-Steagall a little more than a year ago, and nothing I’ve seen since changes my mind. Certainly the bloviations of Warren and McCain don’t.
The essence of the argument for a restoration of Glass-Steagall, as well as “ring fencing” regulations in Europe, appears to be that deposit insurance creates a moral hazard: banks with access to insured deposits take on too much risk. Preventing such banks from engaging in risky investment banking activities supposedly improves the safety of the banking system, and limits taxpayer exposure, by reducing that moral hazard.
There are only two problems with that.
First, access to deposit insurance is obviously not a necessary condition to induce risk taking. None of the stand-alone IBs that took on leverage out the wazoo in the 2000s, and took exposures to highly risky real-estate related securities-Bear, Lehman, Merrill, Morgan Stanley and even, yes, Goldman-had access to deposit insurance. And that was in fact the problem. Nor did they have statutory access to Fed support in the same way banks do. They all relied on very fragile wholesale funding that ran like Usain Bolt when things started to look dodgy.
Second, Glass-Steagall-like restrictions on permitted activities/investments are not sufficient, by a long shot, to prevent commercial banks from taking on risks that threaten their solvency, and the stability of the financial system. Look at all the banking problems in the 70s, 80s, and 90s that occurred despite Glass-Steagall. Sovereign lending to Latin America. The S&L crisis. Lending to Asia before its 1997-1998 crisis. Commercial lending to the energy industry. Need I remind everyone that the phrase “too big to fail” was coined to describe Continental Bank, which became insolvent the old fashioned way: engaging in high risk commercial lending in the era of Glass-Steagall?
The “quiet period” of US banking the 50s and 60s was the result of a dense nexus of costly restrictions on banking activity. Glass-Steagall was a part of that, but not the entire story by a long shot. It just gets the most press, and the best press. The complex web of restrictions on banks and financial intermediation during that period-restrictions that imposed substantial costs-is too hard to explain. So Glass-Steagall has become the poster child for that era. People like Warren and McCain think that Golden Age can be restored by reviving Glass-Steagall. As if.
I am deeply skeptical of restrictions on the activities of financial intermediaries; I am also skeptical of mandated impositions of market structure (e.g., clearing mandates). The underlying incentives remain the same, and these Byzantine restrictions induce attempts to circumvent them. It is better to operate at the level of incentives, through capital requirements, for instance. Yes, there will be attempts to circumvent these too, but at least they provide some incentive for those with the information to internalize the risk-return trade-offs. Structural restrictions, not so much. At all.
Yes, moral hazard induced by deposit insurance matters. But it matters a lot less than other things. Breaking up universal banks will still leave large investment banks reliant on wholesale funding with incentives to lever up, and large commercial banks who can blow themselves up just fine, thank you, by making loans. So the revivification of Glass-Steagall won’t materially reduce systemic risk, but it will induce costly efforts to circumvent the separation, and will sacrifice the synergies between investment and commercial banking activities.
When your diagnosis is wrong, the prescription is likely to be wrong too. And with financial doctors like Warren and McCain, we should have no illusions that they’ve screwed up both.
Spot on, Prof. The Bolt-like egress of overnight funding explains far more of the collapse of the used-to-be investment banks than any argument re Glass-Steagall. And, as Citi and its commercial-bank cohort almost annually demonstrate, there are an almost-infinite number of ways to blow up a balance sheet (you forgot the Mexico debt crisis and the Brady-bonds that bailed these commercial-banking beasts out in the 1990s after they had demonstrated an idiot-savant-like ability to lose money in Latin America the previous two decades).
I still am puzzling out how these guys — commercial and used-to-be-investment banks — continually transform a lot of small and medium successes (e.g., funding a new assembly line for an automaker) into near-catastrophic financial crises (e.g., 1970s thru 1990s Latin Amerian lending, 2008 mortgage market). The old joke used to be the bottom third of the business- and law-school classes ended up running these banks, and they were just intellectually overwhelmed when things got complicated (think Nicholas Brady running Dillon Reed, trying to understand exactly what Dillon Read did when it invested or lent money). Nowadays, we’ve got physics, math and engineering grads populating the financial markets. They design products the bottom-third sells, but could never understand. So, now you’ve got risks these managers cannot comprehend, but, …, that’s no different than it’s ever been. It’s just a different set of risks they cannot comprehend.
It really is a puzzle. They really do find a new way to blow up their balance sheets continually. The only way to limit these blow-ups, I think, is to get back to the partnership structure in which the folks lending money, trading markets, or taking on any type of financial risk actually stand to lose their entire stake in the game (i.e., their own accumulated wealth) if a bad decision is made. The vetting process for different activities in such an environment — and the continual monitoring of those activities — will be of a far higher order than what we’ve got now. If you get a room full of average intellects, all motivated by the growing AND preserving their personal wealth, you’re far more likely to get prudent decisions than if you’re figuring out how to lever the living sh*t out of your balance sheet so your own ROE is infinite as your equity in the venture asymptotically approaches zero.
The only way the infinitely levered alternative works, of course, is if your firm cannot ever collapse as a result of the decisions you make re funding and investing. Then, even mediocre performance can look spectacular because of the leverage. How to ensure that outcome? Hummm … let’s think about what would be needed to massively lever your balance sheet directly (via funding at close to zero in the overnight markets then merrily lending it in the term markets to the entire risk spectrum), and indirectly via trading instruments that have massive embedded leverage (e.g., OTC swaps, options and forwards) that allow you to take on trillions of $ of risk with just a sliver of your own exposure collateralized with borrowed or re-hypothecated funds. Hummm … that would require a massive amount of support.
Still working on how to get that level of support … Gosh, only a government that can raise taxes, print money and control the creation of credit would be able to provide that support. But how can we access that capability? Gosh, that’s a tough one … still working on that … 🙂
Comment by markets.aurelius — July 12, 2013 @ 5:53 am
@markets.aurelius-Thanks. And Nicholas Brady became Secretary of the Treasury. Fools, drunkards, and the USA, indeed.
Re partnership. You could take it further. Eliminate limited liability. Perhaps not going all Lloyds (the insurer, not the bank!) or old Scottish banks to unlimited liability, but some form of expanded joint and several liability.
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