Grieving for Glass-Steagall
Glass-Steagall is dead. Rather like Soviet-era Communist leaders, it has been officially dead since 1999, and actually dead for much longer. Though there was no state funeral, the body was not embalmed or put on display and few people mourned its passing.
Well, not at the time. But fast forward to 2008 and suddenly the Western world – not just the US – exploded in a paroxysm of grief over the demise of Glass-Steagall. “If only Glass-Steagall hadn’t been repealed!” people cried. “Glass-Steagall would have prevented all these banks failing. Glass-Steagall would have stopped all these derivatives being created. Glass-Steagall would have protected everyone’s money”. Glass-Steagall, it seems, could have prevented the entire financial crisis. Never mind that Lehman, Bear Sterns and Merrill Lynch were pure investment banks, with no retail deposits to put at risk. Never mind that AIG was an insurance company and Fannie and Freddie were government-sponsored enterprises – none of which were subject to Glass-Steagall’s provisions. Never mind that Countrywide and most of the other mortgage originators that together created the largest fraud in US corporate history were pure retail lenders and therefore ALSO not subject to Glass-Steagall’s provisions. And never mind that the large universal banks in the US survived the financial crisis relatively unscathed – which might not have been the case if Glass-Steagall had prevented them diversifying.
Ever since, there have been calls for its resurrection in some form or another. The UK is adopting a baby Glass-Steagall. The Eurozone is thinking about a gauzy curtain. And the US has brought in a distant relative – the Volcker Rule. But people are not happy. “WE WANT GLASS-STEAGALL! BRING BACK GLASS-STEAGALL!” they cry. Bizarrely, even people in the UK cry this. The UK never had Glass-Steagall. I wonder sometimes if people really understand what it is they are demanding.
Four years on, there is still an immense amount of nostalgia for the age of Glass-Steagall. And there are repeated attempts to bring it back in some form. The latest attempt is by Senators Warren, Cantwell, McCain and King. Warren admits that Glass-Steagall would not have prevented the financial crisis, and would not end “too big to fail”, but none-the-less wants the large universal banks to be forced to divest their investment banking activities, apparently in order to improve the “culture” in retail banking. But as I’ve noted before, the cultural shift in retail banking away from service and towards aggressive product selling had nothing to do with investment banking: it long pre-dated the repeal of Glass-Steagall and was due to low margins and cut-throat competition in the retail banking sector.
Warren – like many others – wants separation of investment banking from retail to prevent “insured deposits” being used to fund risky activities. Sadly that demonstrates a total lack of understanding of the real funding problems in the financial crisis, or indeed of the nature of bank lending. The problem was actually that wholesale funding – which is prone to runs, as I shall explain – was excessively relied upon to fund risky activities, including retail lending. Retail lending may be “boring”, as Warren claims, but it isn’t “safe”. Deposits that back retail loans on bank balance sheets are at risk. If they are insured, that puts taxpayers’ money at risk just as much as if those deposits were used for securities purchase.
Nevertheless, the calls for separation of “boring” retail banking from “risky” investment banking continue. And there is an important issue here. It concerns the extent to which we are prepared to provide public funds to support the activities of banks. In essence, Glass-Steagall and all its relatives are an attempt to limit the activities that can be supported by public funding – by which what people really mean is liquidity support from central banks.
The trouble is that this is actually impossible. When investment banks are separated from commercial banks they become their customers. Their cash balances sit in commercial banks, because ALL money that isn’t in the form of physical notes and coins sits in commercial banks, one way or another. All financial market trading is intermediated through commercial banks. All new stock issues are intermediated through commercial banks. Payment fails don’t just affect the recipients, they affect the liquidity of the banks through which they are intermediated. In practice it is simply impossible to remove liquidity support from payments arising from market trading, and very dangerous to attempt it – as the Fed discovered when Lehman fell. Remove central bank liquidity support for market trading activities and the entire market collapses like a house of cards.
There is a prevalent belief that if a Glass-Steagall separation were imposed, financial markets could be allowed to collapse without commercial banking being affected. This is completely wrong. When major customers of commercial banks fail, the banks themselves are at risk – and by extension so are their retail customers. The Lehman collapse and consequent market freeze very nearly caused the failure of the global payments network, which would have had catastrophic effects on retail customers. Central banks have to provide liquidity support for ALL payments, whatever their source, not to protect investment banks but to protect the retail customers of commercial banks.
It’s not enough to provide liquidity support after the event, either. Perception of liquidity support is really important. It is the perception of illiquidity that causes bank runs. Institutional investors are nervous creatures. If they believe they might lose access to their funds, they will pull them. Note that this has nothing to do with whether or not there is a real risk of actual loss: even if lending is collateralised with good quality assets there can still be runs. When funding stresses make headline news and there is no apparent liquidity support, people pull their money from the banks affected. So when investment banks are denied liquidity support, institutional investors will pull their funds if they smell trouble – and the knock-on effect is a run on commercial banks, since investment banks are customers of commercial banks. Admittedly, all that really happens in a modern bank run is that money moves from one commercial bank to another – but large unexpected flows of money are destabilising for the banking system as a whole and can be fatal for individual commercial banks.
Liquidity management for commercial banks is a huge issue. Regulatory pressure at the moment is pushing them to increase their holdings of liquid safe assets such as government debt and to fund themselves more with retail deposits than wholesale funds. Retail deposits have traditionally been slower to run than wholesale funds: in the past this has been partly due to retail customer apathy, and partly because retail depositors have had to wait for banks to open in order to withdraw their money, whereas institutional investors can move their money by trading overnight on Far Eastern markets. But this difference is disappearing fast as internet banking makes it possible for retail customers to make payments and move money around at any hour of the day or night. If you make it easier for people to move their money, they are more likely to do so.
Matthew Klein thinks that separating deposits from lending would solve the problem, because it would mean that deposits were never used to fund risky lending. Most bank deposits are moving balances. There are payments in and out of transaction accounts of all kinds all the time: some of those are retail transactions and others come from institutional or market sources. It is not realistic to say “we will provide liquidity support for transactions from retail sources but not from wholesale ones”. The same banks are at risk from payment fails whatever the sources of the transactions, and therefore so are their customers. Klein wants to protect all deposits, irrespective of their size or origin, by backing them with central bank reserves – which neatly solves the transactions problem, but falls foul of popular abhorrence of public support for large institutional, corporate or high-net-worth individual deposits.
Of course many market trades are never cash settled. And it might be assumed therefore that they do not affect commercial banks. This would be wrong. Many of them have cash margin. And cash margin is held in banks. One way or another, all money is held in commercial banks, and it isn’t in practice possible to distinguish between different “pots” of money in the provision of liquidity support, as proponents of structural reform (of all kinds) seem to think. Money is money, whatever its source: if it disappears in transit – whether because of customer default, market freeze or payment system failure – its absence causes problems for both the recipient customers and their banks.
Ensuring the smooth operation of payments has become the primary purpose of central bank liquidity, because advanced economies have allowed themselves to become completely dependent on commercial banks to facilitate the vast majority of cash transactions. Separating out different bits of banking would not eliminate this need: all it would do is create the impression that some types of transaction would not be supported, which would increase the likelihood of highly damaging market freezes or runs even though post-Lehman no central bank would dare withdraw liquidity support for non-retail transactions.
The problem it seems to me is that we have universal access to payments through the same set of commercial banks. There might indeed be a case for completely separating retail (insured) deposit-taking from everything else, perhaps in the form of a new public utility, but it would have to have its own payment systems directly supported by central banks. Would this eliminate the need for central bank liquidity support for non-retail transactions? I’m not sure, frankly. I suspect that even if retail payments were separated from wholesale in this way, there would still be untoward economic effects from financial market failure, which would hurt Main Street just as much if not more than losing their deposits. Hatred of all things non-retail is not sufficient justification for systematic dismantling of central bank support. The economic impact of such an act needs to be fully understood – which at the moment it is not.
What is clear though is that a 1930s-style separation of retail and investment banking is meaningless while all payments go through the same set of commercial banks. We forget that there were no payments systems in the 1930s. Everything was settled in physical cash. Do we really want to go back to that?
Glass-Steagall is dead. It is not appropriate for our modern banking system. Grieve for a bygone age, and move on.
The 21st Century Glass-Steagall Act – James Pethokoukis
Daniel Tarullo questions wisdom of return to Glass-Steagall – Politico
Five facts about the new Glass-Steagall – Simon Johnson
What Glass-Steagall 2 gets wrong: Everything – Matthew Klein
Supermarket banking – Coppola Comment
How to lose 3 million dollars in one second – Chris Arnade
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