Glass-Steagall: A Red Herring for the Financial Crisis

by Sal on January 21, 2010

in Economy,Politics

The causes of the Great Recession of 2008-2010 (and possibly beyond) have been debated and explored in many publications, including on these pages.  One of the arguments that I see frequently, even among Conservatives, is that the banking industry collapse was a direct result of the repeal of Glass-Steagall in 1999 by the Republican Congress and signed into law by President Clinton.  Today, Obama is expected to announce the creation of a new regulatory scheme that would effectively be Glass-Staegall II.  Such a move would be a big mistake, and would do nothing to avert another similar crisis in the future.

Glass-Steagall effectively prevented commercial banks from owning investment banks, and vice-versa.  It was enacted in 1933, but it effectively was relaxed in the 1970s through a waiver program which was often granted.  The 1999 reversal, which so many point to as being the trigger that caused the crisis, was more of a formality to codify in law what was being done in practice through these waivers.  Yet commercial banks owning investment banks, and vice-versa, had absolutely nothing to do with the economic crisis.

The purpose of the Glass-Steagall provision that was repealed in 1999 was to prevent commercial banks from risky investment schemes that would put traditional deposits at risk (one would ask why this is necessary with FDIC and the regulations in place that require banks to have a certain percentage of depositors’ money on hand at any one time?)  Yet when one looks at the failures that occured during the crisis, they were all either commercial banks with no significant investment arm, or investment banks with no significant commercial arm.

In the end, it was the firms who took advantage of Glass-Steagall’s repeal that helped save the economy.  Large investment/commercial conglomerates such as J.P. Morgan Chase and Bank of America were the more solvent banks during this crisis, and helped to purchase the failing pure-investment banks such as Bear Sternes, AIG, and Meryll Lynch,   (investment banks), or the pure commercial banks such as Countrywide and Washington Mutual.  The evidence that combined investment/commercial banks caused the crisis is just not there.  So, big government reacts again, trying to make a red herring out of a deregulation bill that actually probably helped to save the economy.  By putting this regulatory structure back in place, analysts expect stocks of these large banks to go south, given that it will take years for them to figure out what to do, and will cost them profits and prevent them from being competitive in the global economy.

Rather than look at this red herring, why doesn’t the government look at what really caused this crisis, the creation of unsecured debt through government-mandated high-risk home mortgages?  But then, that would require more deregulation as opposed to regulation, and the federal government always hates to get its hands off of anything.

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