10 years since Washington repealed the Glass-Steagall Act, the moment we got royally screwed by the banking system

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By Nomi Prins

This week marks the tenth year anniversary of the repeal of the Glass-Steagall Act of 1933, by the Gramm-Leach-Bliley or Financial Services Modernization Act, marking the moment when we were royally screwed by the banking system. Thank you to all those involved.

It's amazing how downright ebullient, President Bill Clinton was at that signing ceremony on November 12, 1999. an event introduced by then Treasury Secretary (now Obama advisor) Larry Summers, successor to Robert Rubin. Those restricting, anti-competitive Depression era, laws were finally behind us. Awesome.

Fast-forward to now and must of us know how devastatingly expensive that signature was for the American public. Yet, despite our government having deployed or made available over $14.1 trillion worth of federal subsidies to fix Wall Street, the banking landscape is less stable than it was before last year's crisis. And, despite national unemployment approaching double digits, and another record quarter of foreclosures, we stand farther away from the intent of Glass Steagall than ever.

Banks weren't handled with kid gloves then. They were treated like the spoiled, reckless, destructive beings they were. After the stock market crash in 1929, the country sunk into the throes of the Great Depression, characterized by 25% unemployment, bread lines, rampant foreclosures, and general despair. In 1932, the Pecora commission examined the shady banking practices that contributed to the devastation, all of which hinged on one thing - banks had used depositor capital and loans to speculate with. Exactly like the practices going on before and since last fall's financial calamity. The result of that speculation gone wrong tanked the economy. Glass-Steagall logically sought to ensure this wouldn't happen again. It divided up the banking landscape into two parts, commercial banks and investment banks. The federal government would back commercial banks and consumer deposits through establishing the Federal Deposit Insurance Corporation (FDIC). But, it wouldn't be Wall Street's investment bank bookie and b!tch.

Over the decades, the financial sector, armed with cunning lobbyists and overpaid lawyers, took many swipes at Glass-Steagall, but none as devastating as the Gramm-Leach-Bliley Act. Since then, the banking sector's powerful ate its weak, amidst a wave of massive consolidation. Nearly half of the nation's biggest bank mergers took place just before or since that Act was passed. All these mega banks can thus churn deposits and loans into debt or capital to fund speculation, risk, and create a roller coaster of an economy that is defined simply on whether those bets, or asset creations, work or not, at any given moment. Heads they win, tails we lose.

Last fall, the Federal Reserve, and to some extent the Treasury Department, not only blessed, but subsidized the mergers and moniker changes (like seriously, if Carrie Prejean's title can be stripped, certainly Goldman's behavior warrants removal of the bank holding company title), helping too big to fail to become even bigger with riskier profiles than ever before. Only this time they are floated on public assistance. This is not progress. It's expensive insanity. And, it will blow up again. It is a matter of when, not if.

Meanwhile, as reform bills from Senator Christopher Dodd's (D-CT) to Representative Barney Frank's (D-MA), to the plans from the Treasury Department and the White House, make their way from concept to draft to vote, we've got to keep one thing in mind. The beast that is today's complicated, convoluted, risk taking, federal capital sucking, and bonus paying mega-bank is still roaming around free.

As long as it remains out of its cage, creating plans to slow its movements are always going to be much harder, than putting it back in a stronger cage. Though, it's important to have a Consumer Financial Protection Agency, better derivatives regulation (if only that were on the table for real), and 'funeral plans' as Dodd's bill calls them, to put too big to fail banks to bed just before they keel over, it doesn't change the nature of the beast.

And though one way to keep some of our money out of the mouths of the most rapacious banks, would be to reduce leverage limits and increase capital requirements for the riskiest banks, or as Tim Geithner and Fed Chairman, Ben Benanke like to call them, 'the systemically important' ones so they can pay for their own clean-up - this too has a catch.

The more capital banks are required to hold, while being allowed to operate as investment banks that use hoarded capital as collateral for increasing their own borrowing and trading businesses, the less lending they will provide to ordinary citizens and small businesses. Without splitting up the banking structure to avoid the hoard to trade, not to lend, scenario, we are creating legislation to help banks bloat on risk - they will have less than no incentive to do much else.

And as far as regulatory bodies are concerned? I dare any regulator, or for that matter human-being in Washington to come up with one single consistent risk parameter that can be used to determine exactly what percentage of each of the big bank's profits comes from speculative vs. customer driven business. Because, by virtue of how complex they all are, and have been allowed to remain, no two balance sheets are remotely similar - and I'm not talking about accounting terms, I'm talking about risk clarification ones.

Thus, whether we merge all regulators into one ginormous one, or have a council of them to deal with the hard issues of mega-collapse and crisis, or even place one inside the office of every top bank CEO, shadowing him like a probation officer (no that's not in one of the bills, it would just be fun to watch unfold), the beast remains out of the cage.

That's why we need to reinstate Glass-Steagall. Now. We need to dissect the speculative from the boring within our country's financial institutions. And yes, it's possible to achieve. Banks split off pieces of companies and move them around every day. Plus, the Glass Steagall Act didn't wave a magic wand that divided up bank divisions, it ingeniously used banks' own competitive desires against them, by giving banks a one-year period to dramatically reduce the portion of profit they made from investment banking activities to 10% of total profits. Banks were free to choose how to do this, knowing commercial banking got government backing, and investment backing didn't. Betting behaviors are more conservative when it's your own money, and not someone else's on the line. Stability follows.

We need to specifically reinstate section 16 of the Glass-Steagall Act that had restricted national commercial banks from engaging in most investment banking activities, up to a certain small percentage, coming from client directives, not their own proprietary trading. And, on the flip side, we need to reinstate section 21 that restricted investment banks from engaging in any commercial banking up to a certain percentage limit.

Doing these two things, would reduce the more systemically risky competitive desires between these two types of banks that spurs them to merge into institutions that are too big to exist without our help, or take the kinds of leveraged risks that drive short-term profits and bonuses, at the expense of long term financial system stability.

Similar to the original Glass-Steagall Act, commercial institutions would have say, eighteen months to reduce the percentage of their income derived from any type of equity, asset-backed securities, CDO or derivative products origination and trading to 10 percent, and one year to present a plan to do so.

While banks are learning to comply with these new-old laws, we should immediately reinstating lower deposit concentration limits on the banking industry to discourage further consolidation. Plus, we need to force the Fed to do its job to enforce existing limits, or give that enforcement power to the FDIC or another body that shows itself capable of performing this basic regulatory function. Today, two banks, Bank of America and Wells-Fargo are above 10 percent deposit concentration limits, and JPM Chase is close to 10 percent. Thank you for that, Fed. You're fired.

It's time to put the beast back in its cage, while taming it, by re-instating Glass Steagall, and keep it from inflicting even more danger on the rest of us. Meanwhile, we need to support all those in Washington that get this, and keep pressuring those who don't.

Nomi Prins is a senior fellow at the public policy center Demos and author of It Takes a Pillage: Behind the Bailouts, Bonuses, and Backroom Deals from Washington to Wall Street.

Edited November 16, 2009 by Galt's gallstones

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A few responses. None are my own. All from the media.

First, Jamie Dimon's now-famous op-ed in Friday's Washington Post. He's the CEO of JPMorgan-Chase, arguing against Glass-Steagall like legislation:

http://www.washingtonpost.com/wp-dyn/conte...9111209924.html

No more 'too big to fail'

By Jamie Dimon

Friday, November 13, 2009

Our company, J.P. Morgan Chase, employs more than 220,000 people, serves well over 100 million customers, lends hundreds of millions of dollars each day and has operations in nearly 100 countries. And if some unforeseen circumstance should put this firm at risk of collapse, I believe we should be allowed to fail. As Treasury Secretary Timothy Geithner recently put it, "No financial system can operate efficiently if financial institutions and investors assume that government will protect them from the consequences of failure." The term "too big to fail" must be excised from our vocabulary.

But ending the era of "too big to fail" does not mean that we must somehow cap the size of financial-services firms. Scale can create value for shareholders; for consumers, who are beneficiaries of better products, delivered more quickly and at less cost; for the businesses that are our customers; and for the economy as a whole. Artificially limiting the size of an institution, regardless of the business implications, does not make sense. The goal should be a regulatory system that allows financial institutions to meet the needs of individual and institutional customers while ensuring that even the biggest bank can be allowed to fail in a way that does not put taxpayers or the broader economy at risk.

Creating the structures to allow for the orderly failure of a large financial institution starts with giving regulators the authority to facilitate failures when they occur. Under such a system, a failed bank's shareholders should lose their value; unsecured creditors should be at risk and, if necessary, wiped out. A regulator should be able to terminate management and boards and liquidate assets. Those who benefited from mismanaging risks or taking on inappropriate risk should feel the pain. We can learn here from how the Federal Deposit Insurance Corp. closes banks. As with the FDIC process, as long as shareholders and creditors are losing their value, the industry should pay its fair share.

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Establishing this resolution authority will require thoughtful legislation that promotes predictability in the resolution process in accordance with recognized priorities, requires sound risk-management practices, and maintains a level playing field among firms with similar business models. It also requires effective international cooperation, as the implications of a major financial institution's failure are global. This is challenging but worth doing. The alternatives, neither of which is acceptable, are to perpetuate the politically, economically and ethically bankrupt "too big to fail" idea, or to try to impose artificial limits on the size of U.S. financial institutions.

As we have seen clearly over the last several years, financial institutions, including those not considered "too big," can pose serious risks for our markets because of their interconnectivity. A cap on the size of an institution will not prevent that risk. Properly structured resolution authority, however, can help halt the spread of one company's failure to another and to the broader economy.

While the strategy of artificial limits may sound simple, it would undermine the goals of economic stability, job creation and consumer service that lawmakers are trying to promote. Let's be clear: Banks should not be big for the sake of being big. Moreover, regardless of a company's size, it must be well managed. As we've seen in many industries, companies that grow for the sake of growth or that expand into areas outside their core business strategy often stumble. On the other hand, companies that build scale for the benefit of their customers and shareholders more often succeed over time.

To understand the harm of artificially capping the size of financial institutions, consider that some of America's largest companies, which employ millions of Americans, operate around the world. These global enterprises need financial-services partners in China, India, Brazil, South Africa and Russia: partners that can efficiently execute diverse and large-scale transactions; that offer the full range of products and services from loan underwriting and risk management to providing local lines of credit; that can process terabytes of financial data; that can provide financing in the billions.

And it's not just multinational corporations that rely on such a large scale. J.P. Morgan Chase and others supply capital to states and municipalities as well as to firms of all sizes. Smaller banks play a vital role in our nation's economy, too -- but a fragmented banking system cannot always provide the level of service, breadth of products and speed of execution that clients often need. Capping the size of American banks won't eliminate the needs of big businesses; it will force them to turn to foreign banks that won't face the same restrictions.

It is vital that policymakers and those with a stake in our financial system work together to overhaul our regulatory structure thoughtfully and well. While changes may seem arcane and technical, they are critical to the future of the whole economy. It is clear that we must modernize our financial regulatory system. The stakes are simply too high and the consequences too far-reaching to do this hastily. Many of the rules governing our markets today were put in place more than 70 years ago. On a timeline, that Depression era would be closer to the Civil War than to our current century.

Global economic growth requires the services of big financial firms. It also requires that big financial firms be allowed to fail.

The writer is chairman and chief executive of J.P. Morgan Chase.

Next, a thoughtful response to Dimon's piece at the Baseline Scenario:

http://baselinescenario.com/2009/11/13/not...t-make-it-true/

Note to Jamie Dimon: Repeating Something Doesn’t Make It True

with 33 comments

Note: I’ve updated this post at the end with another response to Jamie Dimon, this one by James Coffman. Coffman served in the enforcement division of the SEC for over twenty years, most recently as an assistant director of enforcement, and previously wrote a guest post for this blog.

In the Washington Post, Jamie Dimon asserts that we shouldn’t “try to impose artificial limits on the size of U.S. financial institutions.” Why not?

“Scale can create value for shareholders; for consumers, who are beneficiaries of better products, delivered more quickly and at less cost; for the businesses that are our customers; and for the economy as a whole.”

I don’t know of any serious person who believes this to be true for banks above, say, $100 billion in assets. Charles Calomiris, who studies this stuff, couldn’t find anything stronger to back up the economies of scale claim than a study saying that bank total factor productivity grew by 0.4% per year between 1991 and 1997 — a study whose author thinks that the main factor behind increasing productivity was IT investments.

“Artificially limiting the size of an institution, regardless of the business implications, does not make sense.”

Uh … obviously it makes sense. We all know that having banks that are TBTF is bad. One solution is making them smaller. Big banks may (theoretically) have benefits that outweigh the benefits of shrinking them. But shrinking them makes perfect sense unless those benefits are proven.

“To understand the harm of artificially capping the size of financial institutions, consider that some of America’s largest companies, which employ millions of Americans, operate around the world. These global enterprises need financial-services partners in China, India, Brazil, South Africa and Russia: partners that can efficiently execute diverse and large-scale transactions; that offer the full range of products and services from loan underwriting and risk management to providing local lines of credit; that can process terabytes of financial data; that can provide financing in the billions.”

Does Jamie Dimon really believe this? Doesn’t he run a bank when he isn’t writing op-ed articles? The last time Johnson & Johnson issued debt, it used eleven underwriters. The time before that, it used thirteen. (I only chose J&J because it was the example picked by Scott Talbott, a financial industry lobbyist.) Now, do J&J’s dozens of subsidiaries around the world all get local lines of credit from the same bank? Does J&J really want to be dependent on a single source of credit? (Actually, if that single source has a government guarantee, it could do worse.) If that’s actually true, someone please let me know. But the idea that one of the world’s largest companies would need a one-stop shop for financial services is what defies basic business sense.

Now, I’m willing to concede that there is value to having a global investment bank; at the least, you want trading operations covering all the time zones. And I’m willing to concede that there is some minimum scale to having a sophisticated trading and derivatives operation. But I go back to the number $270 billion. That’s how big Goldman was in 1998, adjusted to today’s dollars. I still haven’t heard a good argument about why the nonfinancial world has changed in a way that requires investment banks that are larger than $270 billion. I also haven’t heard a good argument why a $270 billion investment bank needs to be attached to a $1.5 trillion domestic retail bank (think of Bank of America).

“Capping the size of American banks won’t eliminate the needs of big businesses; it will force them to turn to foreign banks that won’t face the same restrictions.”

On one level, so what? If big American companies want to do business with UBS — a bank that gets bailed out by Swiss taxpayers when necessary — that’s fine with me, and fine with those companies as well. More seriously, of course, that means that Switzerland should also break up its big banks.

“Global economic growth requires the services of big financial firms.”

Just because you keep saying the same thing over and over again doesn’t make it true.

By James Kwak

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And another comment, found at the same link as the previous post:

By James Kwak

Update: And here’s the response by James Coffman.

To the editor:

Jamie Dimon’s opinion piece, “No more ‘too big to fail’,” bases its argument on a false dichotomy and glosses over, at best, the very real problem of interconnectedness.

First, the choice facing lawmakers is not an either/or choice between a resolution authority to wind down failing financial institutions and the imposition of artificial and arbitrary limits on the size of such institutions. While the establishment of a resolution authority is probably necessary, it is not a substitute for restructuring the financial system to prevent TBTF institutions in the future and to remove the threat they pose today. The best, most effective and only proven method for doing this is to separate commercial banking, which is supported by the government’s guarantee in the form of deposit insurance, from the investment banking function, which involves much greater risk resulting from trading, securitization, development and sale of exotic financial products, etc. If those functions are separated, as they were for nearly sixty years until the 1990’s, the market will help control size and risk.

To enhance the ability of market forces to affect size and risk, it is important that investment banks in the future be owned in large part by their employees. If the bankers have their own net worth at stake, they will control the risk the institution assumes. Self-interest is a strong disciplinarian. Investment banks should not be publicly owned. Many of the recent reckless practices can be traced back to the demise of investment banking partnerships. Instead of public shareholders, let them rely on the credit markets and their own equity to finance their activities.

In order for the credit markets to act as a restraining force, all financial institutions should be required to make detailed, uniform and understandable disclosure of their financial activities and balance sheets. Only when such information is available can markets measure risk before lending or investing. The market can discipline risk only when it can measure it.

Finally, Mr. Dimon’s statement that the problem of interconnectedness of finiancial institutions is best handled by a resolution authority would be funny if it weren’t so dangerous and disingenuous. How can a resolution authority cure the interconnectedness problems of a failed institution that has billions of dollars of unhedged and unbacked credit default swaps or other derivatives outstanding? Interconnectedness problems must be identified and addressed before an institution fails. They can best be identified and measured if the underlying transactions that give rise to interconnectedness are known and understood by markets and regulators before the institution fails. The best means for accomplishing this is by establishing transparent clearing mechanisms and disclosure regimes. The banking industry is currently spending millions of dollars on lobbyists in an attempt to weaken such measures.

Our lawmakers need to resolve to never again allow financial institutions to become too big to fail. With the proper market structures in place, the markets can do that more effectively than micro-regulation. If the markets fail at this task, as they have in the past, regulators will have enough accurate and timely information to resolve such problems without huge slugs of taxpayer money and before such problems pose a threat to the world economy.