Many of the old bankers who fought against Glass-Steagall, are urging its reinstatement. I am not sure Congress or the public truly comprehends what G-S was or what the implications of its revival would be upon modern day banks.
When G-S was enacted in 1932, its main objectives were to stop banks from lending to stock speculators and ban the underwriting of securities by commercial banks . In those days, when a company sold stock, an underwriter would buy all the shares and resell them to investors. There was a moment when the underwriter assumed great risk. Today, almost all stock offerings are presold, so underwriters do not incur substantial risk. In the 1930s, banks were financing this business with depositors’ money, exasperating the situation.
G-S also precluded banks from being engaged in most other financial services businesses, such as insurance, investment advisory, private placement of securities and investment in stocks and bonds (now referred to as proprietary trading). For years, commercial banks were only able to take deposits, lend money to corporations and individuals, do trust business and provide related, yet risk free, ancillary services such as cash management. Essentially, the only way banks ran into trouble, after the establishment of the Federal Deposit Insurance Corporation in 1933, was when they made bad loans.
The first meaningful foray of banks into riskier areas were loans to real estate investment trusts (REITs). Most large banks established these finance companies to provide construction loans for real estate projects. The banks established holding companies to own the REITs, then lent each other billions.
A real estate crisis ensued and caused most of REITs that made construction loans to default. In a serious way, these loans departed from ubiquitous working capital and acquisition loans of the past. They were project financing orientated, something the banks had little experience initiating and servicing.
Later, every major commercial bank vied to provide investment banking services prohibited by G-S because they generated substantially higher profit margins than commercial loans. A huge effort to obtain permission to arrange private placements, mergers and acquisitions and such took place. The resistance by investment banks was strong, but bank incursion on these services would not impact their profits materially (What CEO would hire a commercial bank at the time to provide M&A advice? None.) The investment banks were more concerned about the ‘slippery slope,” and incursion into the more lucrative fields of public underwriting. Their concerns were well founded.
To make a long story short, in the 1980s and 1990s, G-S eroded and commercial bankers were given permission to provide virtually every service that investment banks already provided.
The real issues relating to this gigantic metamorphosis had more to do with risk assumption and size than whether commercial banks should be permitted to underwrite bonds and provide M&A services. For instance, banks recognized that while they were trading stocks and bonds with others (on an agency basis with little exposure), they were developing the expertise to invest simultaneously for their own account.
This was the dawn of the proprietary trading business- when banks actually held huge unhedged positions of stocks and bonds. The situation became exponentially more complex and threatening when synthetic securities, including credit default swaps and interest rate hedges, came into being. Banks would inventory these depending on their view of the market. This was a far cry from the deposit-taking and lending business model of the pre-1980s.
Exacerbating the problem was the explosive growth of bank holding companies that were acquiring smaller banks (there are great economies of scale in size) and other types of financial service companies including brokerage, insurance, etc. The problem was that deposits were, in effect, serving as capital for this expansion, even in situations where banking activities were separated legally from other activities.
The result was “too big to fail.” Large banks today cannot default lest they topple the entire financial system. Assuming that the most risky activities will eventually be banned at deposit-taking institutions, I am not very concerned with size. Size creates gigantic synergies and profitability. It is shortsighted to think that a massive breakup of the commercial banks will help our economy.
From the dawn of America, our leaders recognized the importance of the banking system, its health, and its ability to support economic growth. Regulation, therefore, should not be created from emotion. Rather, new rules that govern our banking system should be focused on activities that can create undue financial risk for our banks.