Spooked by Glass-Steagall’s Ghost?

True, major commercial banks, like Citibank and Bank of America, tottered, but they were not at risk because of their securities underwriting for corporate clients or their securities-trading divisions, but because of how they (mis)handled mortgage securities. Mortgage lending, however, is a long-standing activity for commercial and savings banks, mostly unaffected by Glass-Steagall or its repeal.

Some commercial-banking activities are closer to securities trading. The so-called Volcker Rule, proposed by Paul Volcker, the former US Federal Reserve chairman, is a mini-Glass-Steagall, aiming to bar deposit-taking commercial banks from derivatives trading – now seen to be a dangerous activity for them. But, again, although derivatives trading played an important role in the crisis (AIG’s inability, without a government bailout, to honor its risky credit-default swaps is the best example), Glass-Steagall’s repeal did not unleash the riskiest trades in the institutions that failed. Reenacting it will do little, if anything, to remedy crisis-related ills, beyond what the Volcker Rule is supposed to do anyway.

The best case against Glass-Steagall’s repeal is not that mixing investment and commercial banking caused the crisis. Rather, the best case arises from a general sense that financial institutions have become too complicated to regulate and too big to fail even when staying within their traditional businesses. Hence, we should simplify and strengthen them.

But even if those are the goals, the recent focus on repealing Glass-Steagall is not helpful, because it is not the most important way to simplify and strengthen America’s banks. It thereby diverts policymakers’ attention from the main issues. If the financial crisis reveals a structural problem in banking, it is more likely to come from insufficient capital to cushion a bank’s fall, or from too many financial institutions having become too big to fail.

The US Dodd-Frank legislation, enacted in 2010, did (weakly) cap the size of future bank mergers. But, if size is still the problem, more could be done. If big banks have become too complex to regulate, then a workable Volcker Rule is the best way to start simplifying them. And, if the problem is systemically risky derivatives trading in banks and elsewhere, then the priority given to derivatives traders over nearly every creditor ought to be curtailed.

Ironically, Glass-Steagall itself arose in the 1930’s from commercial bankers’ efforts to divert regulators’ attention from other remedies. Small-town bankers throughout the country wanted government-guaranteed deposit insurance, while stronger big-city banks feared that government deposit insurance would put them at a competitive disadvantage. After all, deposits from the small-town banks were running off to big banks in money centers like New York, Chicago, and Los Angeles.

Two decades ago, Donald Langevoort, now a law professor at Georgetown, showed that major bankers – indeed, the leaders of First National City, the predecessor to Weill’s Citibank – proposed Glass-Steagall in lieu of deposit insurance. No big bank was at risk from trading securities then, but the big banks’ investment-banking affiliates were not making money trading and underwriting securities during the Depression, so the banks were willing to surrender that part of their business. The irony is that Congress took up the big banks’ offer to separate commercial and investment banking, but then enacted deposit insurance anyway.

Glass-Steagall was a distraction then; it is a distraction now. If the goal is to shore up the weaknesses revealed by the global financial crisis, policymakers in the US and other countries should first look elsewhere.

Mark Roe is a professor at Harvard Law School.

Copyright: Project Syndicate, 2012.

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