Friday, October 2, 2009

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.

12 comments:

  1. This comment has been removed by a blog administrator.

    ReplyDelete
  2. Bill, what do you make of Deepak Lal's argument that the repeal of Glass-Steagall had a negative effect because it allowed deposit insurance to cover higher risk activities and thus increased moral hazard?

    ReplyDelete
  3. One additional data point that confirms that Glass-Steagal is at best a red herring: Canadian banks don't have Glass-Steagal, and yet survived. The retail banks bought up the investment banks many years ago.

    ReplyDelete
  4. While Lal's argument is plausible, it doesn't appear to be too relevant to the current crisis. We could tell a story where commercial banks were using insured deposits to finance underwriting risky mortgage backed securities. The stand-alone investment banks couldn't get involved in the business because they couldn't find the temporary funding necessary for working capital. Who would lend to an investment bank messing with that sort of junk? Then, when the collapse came, the commercial banks were stuck with unsold inventories of mortgage backed securities. The losses wiped out the banks' capital. FDIC was left with responsibility for the losses.

    What a sad story. But that isn't what happened.

    Stand-alone investment banks had little trouble selling short term commercial paper without deposit insurance. And they weren't just raising working capital for securities underwriting, they were holding large portfolios of the securities for investment purposes.

    As an aside, some of the worst errors were made by Citibank, which funded only a small fraction of its activities with insured deposits. Of course, in the end, it did promise to make loans to the SIV's so that they could pay off the investors, and I suppose their ability to issue FDIC insured CD's could have been a backup. Still, the stand alone investment banks like Bear Sterns and Lehman Brothers were able to do the same without a backup from deposit insurance.

    All that said, regulating deposit insured institutions out of existence may be the least bad way to solve the moral hazard problem in finance. Restricting their lines of business might be a good start.

    ReplyDelete
  5. "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."

    Or maybe the Fed?

    ReplyDelete
  6. Okay, if Glass-Stegall is such an irrelevant red herring then what good was its repeal in the first place? How has its repeal improved anything in the world?

    ReplyDelete
    Replies
    1. "what good was its repeal in the first place?"

      It permitted commercial banks a greater degree of diversification, and opened up a greater degree of competition between financial institutions. Specifically, it appears to be the desire to legalize the Citicorp/Travelers Group merger that prompted its adoption.

      Of course, as with any bill, there is much more to it than that, and perhaps it did do some destructive things. But repealing government protections of investment banks and increasing competition and diversification are some of the ways that it "improved...the world".

      GS repeal didn't permit commercial banks to invest in MBS's, because GS never prevented that.

      Delete
  7. Glass-Steagal's repeal "opened up competition"?

    Hasn't the major problem been consolidation within the industry over the past decade?

    Yes, you get some economies of scale and efficiencies from bigger banks, but it's my recollection that those start to fade out with institutions that are in the $100 billion range.

    Also, when businesses overexpand and steer away from a core focus, bad things usually tend to happen.

    Considering that Citibank has effectively been a ward of the state for the better part of 4 years now, the benefits question should be largely moot -- Citicorp-Travelers was after all the poster child for the exercise in repeal. Even if Glass-Steagal wasn't "the" primary cause of the economic crisis, it's hard to argue that it has actually improved the market operation. There is a very strong argument for keeping investment banking and commercial banking as far from one another as possible; there's also a strong argument in favor of having financial institutions that are capable of some regulatory oversight. The less complexity, the better.

    ReplyDelete
  8. Wow, nice post,there are many person searching about that now they will find enough resources by your post.Thank you for sharing to us.Please one more post about that..
    Security Glass

    ReplyDelete
  9. I would like to thank you for the efforts you've put in writing this blog. I'm hoping the same high-grade web site post from you in the future also. In fact your creative writing skills has inspired me to get my own web site going now. Actually blogging is spreading its wings and growing quickly. Your write up is a great example.
    Security Glass

    ReplyDelete
  10. We might talk about these things all the time, but in reality we are never certain about anything. As a Forex trader, I mainly try to work out simple things which can help me gain better results. At the moment, I am working with OctaFX broker and they are awesome company with having wide benefits which includes the great rebate program that gives me 50% back on all trading orders and that makes me feel highly relaxed with the proceedings.

    ReplyDelete