Reflections on Glass-Steagall and Maniacal Deregulation

Today marks the 10-year anniversary of the passage of the repeal of the 1933 Glass-Steagall Act and related legislation. It is an anniversary worth noting for what it teaches us about forestalling financial crises, the consequences of maniacal deregulation, and the out-of-control political power of the megafinancial institutions.

The repeal of Glass-Steagall removed the legal prohibition on combinations between commercial banks on the one hand, and investment banks and other financial services companies on the other. Glass-Steagall's strict rules originated in the U.S. government's response to the Depression and reflected the learned experience of the severe dangers to consumers and the overall financial system of permitting giant financial institutions to combine commercial banking with other financial operations.

Glass-Steagall protected depositors and prevented the banking system from taking on too much risk by defining industry structure: Commercial banks could not maintain investment banking or insurance affiliates (nor affiliates in non-financial commercial activity).

As banks eyed the higher profits in higher risk activity, however, they began in the 1970s to breach the regulatory walls between commercial banking and other financial services. Starting in the 1980s, responding to a steady drumbeat of requests, regulators began to weaken the strict prohibition on cross-ownership.

Despite herculean efforts by Wall Street throughout the 1990s, Glass-Steagall remained law because of intra-industry and intra-regulatory agency disagreements.

Then, in 1998, in an act of corporate civil disobedience, Citicorp and Travelers Group announced they were merging. Such a combination of banking and insurance companies was illegal under the Bank Holding Company Act, but was excused due to a loophole that provided a two-year review period of proposed mergers. The merger was premised on the expectation that Glass-Steagall would be repealed. Citigroup's co-chairs Sandy Weill and John Reed led a swarm of industry executives and lobbyists who trammeled the halls of Congress to make sure a deal was cut. But as the deal-making on the bill moved into its final phase in Fall 1999, fears ran high that the entire exercise would collapse. (Reed now says repeal of Glass-Steagall was a mistake.)

Robert Rubin stepped into the breach. Having recently stepped aside as Treasury Secretary, Rubin was at the time negotiating the terms of his next job as an executive without portfolio at Citigroup. But this was not public knowledge at the time. Deploying the credibility built up as part of what the media had labeled "The Committee to Save the World" (Rubin, Fed Chair Alan Greenspan and then-Deputy Treasury Secretary Lawrence Summers, so named for their interventions in addressing the Asian financial crisis in 1997), Rubin helped broker the final deal.

The Financial Services Modernization Act, also known as the Gramm-Leach-Bliley Act of 1999, formally repealed Glass-Steagall. Among a long list of deregulatory moves large and small over the last two decades, Gramm-Leach-Bliley was the signal piece of financial deregulation.

Repeal of Glass-Steagall had many important direct effects but the most important was to change the culture of commercial banking to emulate Wall Street's high-risk speculative betting approach.

"Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people's money very conservatively," writes Nobel Prize-winning economist Joseph Stiglitz. "It is with this understanding that the government agrees to pick up the tab should they fail. Investment banks, on the other hand, have traditionally managed rich people's money -- people who can take bigger risks in order to get bigger returns. When repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top. There was a demand for the kind of high returns that could be obtained only through high leverage and big risk-taking."

This is a very important part of the story of what created the financial crisis.

What lessons should be learned from the 10-year debacle?

First, Glass-Steagall's key insight was in the need to treat regulation from an industry structure point of view. Glass-Steagall's authors did not set out to establish a regulatory system to oversee companies that combined commercial banking and investment banking. They simply banned the combination of these enterprises. Cleaning up the current mess, we need strategies that focus on industry structure -- meaning, especially, that we must break up the big banks -- as well as more traditional regulation.

Second, we need to return to Glass-Steagall's more particular understanding: depository institutions backed by federal insurance protection cannot be involved in the risky, speculative betting of the investment banking world. (Notably, the Glass-Steagall problem is now worse than it was before the financial crisis, following JP Morgan's acquisition of Bear Stearns, and Bank of America's takeover of Merrill Lynch.) Moreover, we need not just to reinstate Glass-Steagall, but infuse its underlying principles throughout the financial regulatory scheme. Commercial banks should not be in the business of speculation. They have a job to do in providing credit to the real economy. They should do that. Their job is not to engage in betting on derivatives and other exotic financial instruments.

Third, giant financial institutions exercise too much political power, and for that reason alone must be broken up.

Fourth, we need broad reform in the area of money and politics. We need public financing of Congressional regulations, even stronger lobbyist reforms, and tight restrictions to close the revolving door through which individuals spin as they travel between positions in government and industry.

A year ago, as the financial crisis was unfolding, it seemed very plausible that these reforms would be seriously debated in Congress. Three months ago, it appeared that Wall Street had successfully maneuvered to keep them off the table. But in Congress a recognition is now settling in that regulatory reforms on the table are failing to deal with the problems of size and industry structure -- and that there may be a severe political price to be paid for such failure. Suddenly, it seems that common sense may again be politically viable.