Reinstate Glass-Steagall: Roubini says yes

I have been keeping an eye on various proposals to "reinstate" Glass-Steagall for quite some time. Sometime I ought to post a more comprehensive list as to who is in favor (and in what sense) and who is opposed. Clearly the folks at New Economic Perspectives (from Kansas City and Beyond) are so inclined. So too Nouriel Roubini, as reported by Tech Ticker, 4/11:

Roubini supports the 'Volcker Rule' which would force banks to stop proprietary trading. "Why should you use taxpayer money to essentially subsidize risky prop trading?," he asks.

Roubini goes even further, saying Congress should reinstate Glass-Steagall which separated commercial banking from investment banking. "If Goldman Sachs wants to be a hedge fund, so be it, but there should be a level playing field," he argues. "Other hedge funds don't borrow at zero rate with the guarantee of the government."

For more on the "Volcker Rule", and financial reform: 5/13 CNN Money video featuring Senator Ted Kaufman, D-Del that is worth a look, and 5/11 link featuring Nouriel Roubini.

Paul Krugman's ideas seem to differ a bit, and seem to be where the Obama Administration is trying to lead Congress. Here's Krugman, Financial Reform 101, 4/1:

It's easy to see where concerns about banks that are "too big to fail" come from. In the face of financial crisis, the U.S. government provided cash and guarantees to financial institutions whose failure, it feared, might bring down the whole system. And the rescue operation was mainly focused on a handful of big players: A.I.G., Citigroup, Bank of America, and so on.

This rescue was necessary, but it put taxpayers on the hook for potentially large losses. And it also established a dangerous precedent: big financial institutions, we now know, will be bailed out in times of crisis. And this, it's argued, will encourage even riskier behavior in the future, since executives at big banks will know that it’s heads they win, tails taxpayers lose.

The solution, say people like Mr. Volcker, is to break big financial institutions into units that aren’t too big to fail, making future bailouts unnecessary and restoring market discipline.

It's a convincing-sounding argument, but I'm one of those people who doesn’t buy it.

Here's how I see it. Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail. As it turned out, the Fed was dead wrong: the wave of small-bank failures was a catastrophe for the wider economy.

The same would be true today. Breaking up big financial institutions wouldn’t prevent future crises, nor would it eliminate the need for bailouts when those crises happen. The next bailout wouldn’t be concentrated on a few big companies — but it would be a bailout all the same. I don’t have any love for financial giants, but I just don’t believe that breaking them up solves the key problem.

So what's the alternative to breaking up big financial institutions? The answer, I'd argue, is to update and extend old-fashioned bank regulation.

And this is exactly what the Senate is now doing. Sort of. Economics of Contempt (EoC) is generally OK with regulatory reform that doesn't get too bizarre. On the other hand, EoC is particularly against the Sen. Blanche Lincoln's "Section 106" proposal as per derivatives. To EoC, 5/8:

Bloomberg has an excellent story on the origins of Blanche Lincoln's disastrous swaps proposal (the infamous "Section 106") — Bloomberg: How ‘Hard to Fathom’ Derivatives Rule Emerged in U.S. Senate. Short version:

The idea arose from a mix of policy debate, campaign politics and personal relationships -- and little consideration of the business or economic implications, according to interviews with Senate aides, administration officials and industry lobbyists.

Read the whole article. Oh by the way, Paul Volcker has now also come out against Section 106. Sheila Bair penned a letter to Lincoln sharply criticizing Section 106 last week, and the Fed circulated a memo on the Hill a couple weeks ago arguing that Section 106 should be deleted. …

The whole point is that Section 106 doesn't distinguish between prop trading and market-making. It bans banks from doing both. [Robert] Reich clearly has no clue what Lincoln's Section 106 proposal is even about — and yet he's already declared that failing to support it would be "pandering to Wall Street."

Look, this isn't difficult. Swaps are a critical part of modern banking. Just like normal commercial lending requires banks to serve as intermediaries between savers and borrowers, the swaps market also requires intermediaries (known as dealers, or market-makers). These intermediaries borrow short and lend (through swaps) long; they are susceptible to runs; and their disorderly failure can cause severe collateral damage to the real economy. Pretending that swap dealers aren't engaged in an important banking function by refusing to call them "banks" is not just delusional, it's also dangerous. And yet this is what Blanche Lincoln's Section 106 proposal aims to do.

Maybe Section 106 won't last long. According to one source, 5/12 "Reuters was reporting Monday that … Section 106, is going to get excised, perhaps this week."

Comments

[Ken Houghton]

Section 106 is there to help Blanche Lincoln get re-elected; it looks as if she's doing something. It will be gone (barring a runoff) at 9:00am Wednesday. Or maybe noon, if they're worrying about appearances.

[bailey]

Krugman is a nonstarter. He was WRONG on NAFTA, he was WRONG to stay silent on Glass-Steagall, he was WRONG to stay silent on the Boskin Commission, he was WRONG to stay silent on housing. He likes to point to one counter-point with Greenspan as evidence of his independence. Apart from his attacks on "Chauncey" Bush, he's been weak, very weak for a long time.

[Gary Anderson]

I am concerned that Krugman just wants to keep the financial world order intact. He has sold out. I also believe that banks should not be permitted to write swaps on loans. That resulted in the liar loans of the past. There is no reason to believe that this could not happen again. Investors will be fooled by swaps in the future just like they were fooled by swaps in the past. It may take a few years but it will happen again.

[ronald david greenberg]

Re: "Here's how I see it. Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small."

Comment: But no deposit insurance existed then, so didn't runs on banks cause or exacerbate the problem causing them to fail?

[dave iverson]

Ronald,

"It's complicated", as they say. It seems there was some insurance in force, technically, at the state level. But in a massive liquidity crisis even states can't pass muster. And maybe nation states can't either. A main contributing factor was that some countries were going off the gold standard and people were uncomfortable with paper money, even if supposedly backed by metal. Here's a snip from a history of the FDIC:

"Once again, the Federal Reserve failed to inject sufficient liquidity into the
banking system. In 1931, policymakers were primarily preoccupied with international
monetary matters. The abandonment by Great Britain of the gold standard in September
1931 aroused general fears that other countries might follow. These fears caused many
foreigners with U.S. bank accounts to convert deposits to gold in the New York money
market. To stem the ensuing gold outflow, the Federal Reserve Bank of New York
sharply increased its rediscount rate. Although this action achieved the desired effect, no
steps were taken to augment already depleted bank reserves through extensive open
market purchases of securities. By ignoring domestic financial considerations, the
Federal Reserve added to the banking industry’s woes.

The effects of these liquidity crises were reflected in the bank failure statistics.
About 2,300 banks suspended operations in 1931. The number of failures thus exceeded
the average number for the 1921-1929 period by almost threefold. Losses borne by
depositors in 1931 exceeded losses for the entire 1921-1929 period. ...

In an attempt to ease bank liquidity problems, the National Credit Corporation
was organized by private-sector bankers in October 1931 to extend loans to weakened
banks. However, the corporation failed within a matter of weeks. Business leaders
appealed to the federal government for assistance. The Hoover Administration responded
by recommending two measures. The first resulted in the creation, in January 1932, of a
new major federal lending agency, the Reconstruction Finance Corporation (RFC). One
of its primary functions was to make advances to banks. By the end of 1932, the RFC
had authorized almost $900 million in loans to assist over 4,000 banks striving to remain
open. The RFC might have assisted more banks had Congress not ordered it to disclose
publicly the names of borrowers, beginning in August 1932. Appearance of a bank’s
name on the list was interpreted as a sign of weakness and frequently led to runs on the
bank. Consequently, many banks refrained from borrowing from the RFC.

The second measure supported by the Hoover Administration – the Glass-Steagall
Act of February 27, 1932 – broadened the circumstances under which member banks
could borrow from the Federal Reserve System. It enabled a member bank to borrow
from a Federal Reserve Bank upon paper other than that ordinarily eligible for rediscount
or as collateral for loans. Although the amounts subsequently borrowed were not large in
the aggregate, the measure did aid individual banks.

The generally improved banking situation during the ensuring months was
marked by a significant drop in both the number of bank failures and depositor losses.
However, other signs suggested that the industry’s troubles were far from over. Waves of
bank failures still occurred during the year. Another disquieting sign was the emergence
of bank moratoria. Initially, they were declared by individual local communities. Later
that year, Nevada proclaimed the first statewide moratorium when runs on individual
banks threatened to involve banks throughout the state. Similar moratoria were to play a
role in the events that culminated in the nationwide bank holiday of 1933.

The Banking Crisis of 1933

During the winter of 1932-1933, banking conditions deteriorated rapidly. In
retrospect, it is not possible to point to any single factor that precipitated the calamitous
events of this period. The general uncertainty with respect to monetary and banking
conditions undoubtedly played the major role, although there were specific events that
tended to increase liquidity pressures within the system. Banks, especially in states that
had declared bank moratoria, accelerated withdrawals from correspondents in an attempt
to strengthen their position. Currency holdings increased significantly, partially in
anticipation of additional bank moratoria.

Additional liquidity pressures were brought about by concern relating to the
future of the dollar. With the election of Franklin D. Roosevelt in November 1932,
rumors circulated that the new administration would devalue the dollar, which led to an
increase in speculative holdings of foreign currencies, gold and gold certificates. Unlike
the period of international monetary instability in 1931, a significant amount of the
conversions from Federal Reserve notes and deposits to gold came from domestic
sources. These demands placed considerable strain on New York City banks and,
ultimately, on the Federal Reserve Bank of New York.

It was the suddenness of the withdrawal demands in selected parts of the country
that started a panic of massive proportions. State after state declared bank holidays. The
banking panic reached a peak during the first three days of March 1933. Visitors arriving
in Washington to attend the presidential inauguration found notices in their hotel rooms
that checks drawn on out-of-town banks would not be honored. By March 4,
Inauguration Day, every state in the Union had declared a bank holiday.

As one of his first official acts, President Roosevelt proclaimed a nationwide bank
holiday to commence on March 6 and last four days. Administration officials quickly
began to draft legislation designed to legalize the holiday and resolve the banking crisis.(p 21-2)

From: http://www.fdic.gov/bank/historical/brief/brhist.pdf

In my opinion the whole thing rests on broad-based trust in government and "banking systems." In that era trust was lost and the whole scheme collapsed. But what do I know. I just occasionally muse about this stuff and try to make some sense of it.

[ronald david greenberg]

Thanks for the above information. These other measures mentioned above could have had a weighty effect but apparently did not for a combination of reasons mentioned above as well.

I agree, in any event, with Roubini generally, and your comments to my post. A lingering question for me is that competition (with, e.g., all "too big-fail banks" being smaller) coupled with deposit insurance might impart necessary discipline.

And, further, Glass-Steagall should reinstated, in a fairly strong form, with or without covered bonds usage (for all financial institutions) or securitization (for investment banks only, not depositary institutions (banks, credit unions, et al.)).

You appropriated my usual thunder "But what do I know". Economics is not an exact science (like present-day physics (!) with its string and other exotic (?) theories).

Banking is critical to the health and wealth of worldwide society. Dodd-Frank and other measures (e.g., in England) may be effective. In addition I hope that the general tone and culture found in the financial system tends to emphasize its historic (on the whole) honorable, along with its profit, dimension.