Why the US should avoid a banking break-up

The return of the Glass-Steagall Act would destabilise the global financial system and more sophisticated approaches exist.

The Republican Party blindsided Wall Street at its convention yesterday when it inserted the restoration of the Depression-era Glass-Steagall Act into its final platform. (AFP Photo/Robyn Beck)

The Republican Party blindsided Wall Street at its convention yesterday when it inserted the restoration of the Depression-era Glass-Steagall Act into its final platform.

The Act, repealed by Bill Clinton in 1999, separated commercial banking activities from investment banking’s exposure to securities markets. If a 21st Century version of it were to be introduced, it would mean the break up of the big Wall Street banks with inevitable spillovers into global banking activity and the global financial system more broadly.

The surprise Republican stance lines Donald Trump up with the “liberal” segment of the Democrats. Bernie Sanders and Elizabeth Warren are both aggressive advocates for a return of Glass-Steagall.

Hillary Clinton, while she has talked about breaking up the big US banks, has said she is opposed to a simple reintroduction of Glass-Steagall. She has also outlined plans to extend the cumbersome Dodd-Frank legislation introduced in response to the 2008 financial crisis beyond conventional banking to “shadow” banks.

While there is undoubtedly a major strain of politics behind the Republicans’ decision to put banking separation on their platform (a key strand to their attacks on Clinton are accusations that she’s too close to Wall St and in any case big bank bashing is popular with politicians and voters everywhere), since 2008 the return of Glass-Steagall has been a mainstream topic of debate.

That’s despite the reality that the financial crisis wasn’t triggered by big bank failures (although it nearly caused a number of them to fail) but started within the monoline investment banks and the shadow banks. It was the linkages and interconnectedness, mainly via funding, between shadow banking and traditional banking that infected the big global banks.

The concept of a “universal” bank which straddles traditional retail and commercial banking and investment banking grew out of the deregulation of British banking and finance markets in the 1980s, which ignited a wave of consolidation and integration of British and European banks and investment banking.

The US, concerned that its banks were losing global ground, finally (at the instigation of Republican senators) repealed Glass-Steagall and ignited its own wave of cross-sector mergers of banks, investment banks, insurers and securities businesses.

At the time, the wider environment was increasingly market-driven and deregulatory and there was a conviction that the new financial conglomerates, their shareholders and their creditors could largely self-regulate, with a layer of relatively light regulation and prudential supervision to protect financial systems.

What wasn’t properly appreciated, until 2008, was the way the incentives within these conglomerates would encourage risk taking. Relative to traditional banking activity, investment banking generates (or at least did) very high returns on capital because of higher levels of volatility and risk they are exposed to and price into their dealings.

Lower risk capital generated within traditional banking inevitably was directed to less capital-intensive, higher-returning and higher-risk activities by executives in the groups remunerated on the basis of short-term performance that wasn’t risk-adjusted.

Since the crisis and the massive taxpayer bailouts of US, British and European banks and financial institutions that it forced, there has, of course, been a lot of re-regulation of financial institutions to force them to hold more liquidity and capital and more risk-sensitive capital to “encourage” them to reduce their exposures to riskier investment banking-type activity.

Inevitably that has seen a dramatic growth in shadow banking, which is why Clinton is talking about extending the US regulatory net, but the stress-testing in the US and Britain (but perhaps not in Europe, at least to the same degree) has shown the “too big to fail” institutions are now far stronger, less leveraged and less exposed to risk than they were leading into 2008.

Unpicking the financial conglomerates could be messy, difficult and could generate unintended consequences. The “Volker Rule” restrictions on principal trading in the US have, for instance, had a material impact on the depth of liquidity in financial markets.

The global banking conglomerates provide a wide range of financial services across the spectrum of banking, investment banking and securities dealing activities to global companies and institutions. They help facilitate the cross-border financial flows that underpin the architecture of the global financial system.

In the Britain, policymakers have come up with a different approach to that of building legislative walls between banking and other segments of the financial system.

The Vickers Commission’s 2011 report on British banking came up with a quite sophisticated set of proposed reforms that British regulators are now working steadily towards implementing, with a start date of 2019.

Under the proposals, British banks will “ring fence” their traditional retail and small business banking activities within a discrete entity with its own independent majority of directors and with very conservative capital requirements. What the banks put inside that “fence,” is, to some extent, discretionary (they could include corporate deposits and lending but that would attract the tougher capital requirements).

The ring-fenced subsidiary would have access to the Bank of England’s lender of last resort facilities — and ultimately taxpayer support if required.

Global wholesale and investment banking and other higher-risk activities would be outside the fence, within a different legal entity, and have lower capital requirements. If they failed, it would be the shareholders and creditors’ problem and loss.

That approach is costly — the implementations costs for the big British banks are estimated at hundreds of millions of pounds each and there will be a significant increase in ongoing administration costs and it still isn’t clear how the Brexit vote and the potential shift of some investment banking and securities market activity from Britain to Europe might interact with it to reshape the British system.

Britain is seeking to both create a safer core domestic banking system for depositors, taxpayers and the British economy, while still allowing its bigger institutions to offer a full range of financial services globally, if they choose, while remaining within the jurisdiction and under the oversight of the British prudential regulators.

That would appear to be a more intelligent and less risky approach than simply breaking up traditional banking and casting investment banking and other non-core financial services activities into the less-regulated (and often non-regulated) shadows of the global system, which is what could flow from a simple reintroduction of Glass-Steagall.

Strengthening core banking systems in response to the financial crisis (which has been happening at both global and national levels) is desirable.

Doing that at the potential expense of global systemic stability, which might be the result if investment banking were pushed towards the system’s shadows, wouldn’t be a desired or desirable outcome.