This week, Senators John McCain, Elizabeth Warren, Maria Cantwell, and Angus King introduced legislation to essentially reinstate the Glass-Steagall Act of 1933, which was repealed in 1999. It would force financial institutions to be either pure commercial banks or pure investment banks.

Glass-Steagall was wrong and indeed harmful the first time around, and it is wrong and harmful now.

The arguments for Glass-Steagall usually fall along one of four lines, none of which has merit.

No conflict of interest problem
The most common argument is that having commercial banking activities (such as taking in deposits and making loans) and investment banking activities (securities underwriting) leads to conflicts of interest. For example, suppose a bank made a loan to a firm, and then the firm suddenly faced some sort of cash shortage. The bank could be inappropriately tempted to underwrite a bond or equity issuance of the firm to ensure that the firm is able to pay the loan back.

However, a 1994 matched pair study by Randy Kroszner and Raghuram Rajan provides fairly conclusive evidence that this is not the case. The two match bonds originating from commercial banks between 1921 and 1929 with similar securities originating from pure investment banks during the same time span. The matching criteria include S&P/Moody’s ratings, date of issuance, maturity, payment provisions, size, and conversion provision.

Kroszner and Rajan then compare performance data over time and find statistically significant evidence that commercial bank underwritten issues defaulted less frequently than investment bank underwritten issues, and when they do default, investors would recover more. The difference is even more pronounced when the volume of the issues is considered, since commercial banks underwrote larger issues. By 1940, 28% of investment bank underwritten issues had defaulted, whereas 11% of commercial bank underwritten issues had.

Instead, by comparing ratings and yields at issue with subsequent performance, the study provides empirical evidence of efficient markets: investors appear to have rationally discounted the price of bonds issued by commercial banks for potential conflicts.

Decreasing instead of increasing riskiness
A second popular argument is the idea that a commercial bank that has investment banking activities will be riskier and more likely to fail than a pure commercial bank. This argument has it exactly backwards.

According to Eugene White (1986) cited in Kroszner and Rajan, commercial banks which underwrote security issuances before Glass-Steagall were less likely to fail than pure commercial banks, and had on average the same earnings variance and capital ratios.

There is a very straightforward theoretical explanation for this: diversification. If a commercial bank’s only source of revenue is its commercial banking deposit and loans operations, then if this service experiences a temporary shock, the bank has nothing else to help it ride out the storm. This is not the case if the bank can also get revenue from securities activities.

Thus, it would seem that the imposition of a separation between commercial and investment banking between 1933 and 1999 could very well have been harmful by preventing banks from diversifying their revenue streams.

Political power; economies of scope
One reason to reinstate Glass-Steagall that has recently become popular is the idea that the law restrained the political power of banks. Investment bankers and commercial bankers have conflicting interests, and thus the political influence of each is offset by the other, Luigi Zingales writes in the Financial Times.

This is silly. The idea would seem ludicrous in any other context. Should farms be restricted to growing only one type of crop so that the sway of the farm lobby and the subsidies it receives would be reduced by, say, corn farmers duking it out with tomato farmers for funds?

Of course not. Farms that grow more than one crop are more productive because of economies of scope: goods or services are produced more cheaply when a firm produces a range of similar goods or services. The same is true in finance. By providing both commercial and investment banking services, a firm becomes more efficient. This means lower costs for consumers and yes, higher profits for firms.

The feel good factor
“I would say that ‘passing this law will annoy Jamie Dimon’ is a sufficient reason to do it,” writes Matt Yglesias of Slate on the legislation.

After the 2008 crisis, it’s certainly tempting to agree. Unfortunately, vengeance is not a sustainable source of a prosperous society.

Last, it should be noted that countries known for financial stability, such as Canada, have nothing like Glass-Steagall, and that Glass-Steagall would have done nothing to prevent the failure of the pure investment bank Lehman Brothers or pure commercial bank Washington Mutual in 2008.

Simply put, there is significant evidence that reinstating Glass-Steagall would not just be mistaken, but would be harmful. It prevents banks from stabilizing their income by diversifying its source, and blocks economies of scope which lower costs. Congress should reject the legislation.

 

One Response to Glass-Steagall was wrong then and is wrong now

  1. Phil Carlitz says:

    You forgot what I think to be the largest argument for glass steagall-too big to fail. Not saying its correct or not but Ben bernanke and jack lew have recently spoken about the need to end too big to fail. They use this as a justification for implementing Dodd frank. Just my .02. As far as I know, big mergers like Citigroup led to massive instability in global markets in the wake of September 2008.

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