Don't Revive Glass-Steagall

Over the past few weeks I have read several proposed solutions to the current banking crisis that seem to advocate for a return to the flawed regulatory system put in place after the Great Depression 1.0. In particular, there have been several suggestions that Glass-Steagall should be reinstated. Glass-Steagall, officially known as the Banking Act of 1933, not only established our deposit insurance system (FDIC), but separated deposit banking from investment banking.  66 years later, in 1999, President Clinton signed into law the Gramm-Leach-Bliley Act that repealed the portion of Glass-Steagall that once again permitted integrated financial services companies. Reinstating Glass-Steagall will not prevent the systemic crisis that has occurred with our banking system. The tools are already in place that could have prevented the coming collapse, but it is the failure of government to use those tools to provide transparency to the markets that has set up the situation.

 Our entire system is based on faith and credit (in the sense of trust). There can only be full faith and credit with full transparency. (See, Faith and Credit - Act Now to Restore Confidence.) Full transparency means that banks that accept other people's money (depositors, stockholder, bondholders) must report fully and accurately its assets and liabilities. As a depositor, I want to know whether the bank that holds my money is taking excessive risk or gearing up with excessive leverage.  The government's role should be to ensure the transparency of the markets, and my deposit bank in particular, with timely and accurate disclosures so that risk may be assessed. If my bank's leverage ratio goes to high, I will need information to make a decision as to whether I will keep my money in the bank or move to another, safer institution.  

The trouble is, that our government has abandoned its role in ensuring transparency. The FDIC will not disclose its bank ratings out of fear that depositors will do just what they should do - take their money and run. To date, Congress is refusing to enforce mark to market accounting - which means that no one really knows the value of assets on the banks' balance sheets (and thus also obfuscates the leverage ratio). Frankly, if the assets can not be readily valued, they should not be counted as assets at all, and should not go into the leverage/reserve requirement calculations.  Banks play games with their leverage as well by sweeping in deposits overnight only to re-lend them to the same borrowers the next day. The bottom line is that noone can tell what the banks assets are worth or what its leverage ratio is. A few bloggers, including Karl Denninger (who unfortunately also advocates for reinstating Glass-Steagall), have suggested that reporting daily leverage ratios will help. Frankly, in this day and age, with there is no reason that we cannot have much more frequent financial reporting than on a quarterly basis. Daily reporting may be overkill, but it is the kind of step that will provide the transparency that is needed to save the system. Once a loan goes bad or an asset is devalued, the depositors and investors will know and can use that information to make an informed decision. That transparency will provide faith and credit in our system. Strong, conservative institutions will be rewarded with numerous depositors, and riskier ones will find the type of depositors that are willing to bear the risk.

At the same time, while ensuring disclosure, we need to make sure the government does not rig the system to play favorites or put us at a competitive disadvantage. Government needs to take steps to make sure true and accurate information is available, but cannot intervene in the workings of the market. Government intervention and market regulation simply will not help instill faith in the banking system or cause anyone to give credit to the banks. Reinstating Glass-Steagall, or other artificial devices from the GD 1.0 such as the uptick rule and unit banking, will only weaken our system and put it at a competitive disadvantage with other countries banking systems, and delay recovery. Keep in mind, that Congress separated comercial banks from investment banks at the same time it instituted guaranteed deposits.  The government wanted to make sure that there would be a way to finance the system risk free.  Separating the banks removed that risk somewhat.  However, even with those market regulation devices, systemic collapse was and is still possible.  If the goal is to make sure there is enough funds for deposit insurance, the banks should be assessed fees (premiums) in accordance with the risk they take.  In other words, if a combined financial services entity is deemed more at risk than a stand alone savings bank, then the premiums it should contribute to the FDIC should be greater.  Another point to remember is that Glass-Steagall did not prevent integrated financial services companies.  We still had those entities we referred to as "non-bank banks" and a whole host of other entities that circumvented the Glass-Steagall prohibition.  A return to those days will only prevent the financial institutions from regaining strength, and make them more susceptible to risk from economic cycles.  Not to rehash arguments made before the passage of GLB, but it was noted by both parties in Congress that money flowed out of deposit institutions and into investment banks during economic booms, and the reverse occurred during economic busts.  Allowing diversified financial institutions actually strengthened the system.

What destroyed the system was the abdication of reporting oversight.  The truth was obscured.  Without sunshine, depositors and investors play a rigged game.  What the people need is knowledge and accurate information, not the government assuming the role of a parent dictating which practices are good and allowable, which ones are bad and prohibited. If faith and credit are the key to the system, then transparency is the lock into which that key fits.