The Crisis and Glass Steagall

Bruce Judson calls for Glass-Steagall 2.0. Arnold Kling reponds, arguing that Glass-Steagall 2.0 is a misnomer, and that creating a system that allows insolvent financial institutions to fail is desirable. Too big to fail must end. I endorse Kling's view.

Glass-Steagall prohibited commercial banks from underwriting securities and investment banks from accepting deposits. Commercial banking and investment banking were separated.

We can tell stories about problems that could develop because commercial banks are combined with investment banks. We can tell stories where these problems involve subprime lending and mortgage backed securities. We can even tell stories where these problems balloon into a financial crisis.

However, these stories do not reflect what actually happened, and so, Glass-Steagall is irrelevant to the actual problems that occurred.

Most of the commercial banks are in trouble because they hold large portfolios of mortgage backed securities. Glass-Steagall didn't prohibit banks from investing in securities.

The investment banks are in trouble because they also hold large portfolios of mortgage-backed securities funded by very short term commercial paper. Glass-Steagall didn't prohibit investment banks from issuing commercial paper or investing in securities.

We can imagine scenarios where the investment bank division of a combined firm convinced the commercial bank division to purchase risky securities that it had underwritten. But most commercial banks don't have investment bank divisions, and most bought mortgage backed securities too.

Commercial banks purchased mortgage backed securities because they were AAA rated, had decent yields, and the regulators required little capital. It wasn't because they all had investment bank divisions that needed to get rid of the securities.

Similarly, we can imagine a commercial bank dumping its lowest quality mortgages and "making" its investment bank division securitize them, and then, when the house of cards collapsed, their investment bank division would be caught with them. While there are problems with this story (and the others,) it isn't what happened.

Mortgage banks sold bad loans to investment banks, both stand alone investment banks and investment banks combined with commercial banks. And the investment banks underwrote mortgage backed securities and held the securities for investment purposes.

Finally, we could imagine that the investment banks were underwriting mortgage backed securities, and as part of the business, they had yet unsold securities. When the collapse of that market occurred, they were stuck with them and lost money. Somehow, the commercial bank divisions were on the hook for the loss. Perhaps because the commercial bank division was lending to the investment bank division. And so, the risky investment bank operations dragged down the commercial bank.

Interesting story. Close to the story told about why Glass-Steagall was supposed to be a good idea in the 1930s. Not closely related to the real reason why it was passed (because politically important investment banks didn't want to face the competition of commercial banks horning in on their lucrative operations.)

And, most importantly, it has nothing to do with the current crisis. The investment banks weren't stuck with mortgage backed securities because they hadn't got rid of them yet. They were holding them because they thought it was a good investment. The investment banks were not funding their operations with commercial bank loans at all, much less loans from "captive" commercial bank partners, but with short term commercial paper.

With very creative interpretation, one might argue that the investment banks were really operating commercial banks. They were indirectly funding mortgage loans and the short commercial paper was like deposits. They were no longer just funding an underwriting operation and using commercial paper for "working capital" and having securities pass through their hands as they underwrote them and sold them off to investors. No, they were issuing quasi-deposits and making quasi-loans. But... it would take very creative interpretation of Glass-Steagall to prohibit this as being illegal competition with commercial banks.

And the reality is that both investment banks and commercial banks are in trouble because they held large portfolios of mortgage backed securities, not because they were tied to one another. As far as I can see, if Glass-Steagall had existed, the same thing could have, and I believe, would have, happened.

Glass-Steagall is a red herring. I think it is brought up because it is the only bit of deregulation that seems slightly relevant, and some people cannot accept that misregulation, and entrepreneurial error, rather than deregulation, was the key source of the problem. Banks and investment banks made errors and lost money. Bailing them out, of course, means that the motivation to avoid error in the future will be less. The regulators were similarly in error, and really, if anything, encouraged the commercial banks and investment banks to head down the road to disaster.