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A New Glass-Steagall Act

by | July 16th, 2013 | 12:22 pm
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On July 11, four senators unveiled the 21st Century Glass-Steagall Act. The pushback from people representing the megabanks was immediate but also completely lame. The weakness of their arguments against the proposed legislation is a major reason to think that this reform idea will ultimately prevail.

The strangest argument against the act is that it would not have prevented the financial crisis of 2007–08. This completely ignores the central role played by Citigroup.

It is always a mistake to suggest there is any panacea that would prevent crises—either in the past or in the future. And none of the senators proposing the legislation—Maria Cantwell of Washington, Angus King of Maine, John McCain of Arizona, and Elizabeth Warren of Massachusetts—have made such an argument. But banking crises can be more or less severe, depending on the nature of the firms that become most troubled, including their size relative to the financial system and relative to the economy, the extent to which they provide critical functions, and how far the damage would spread around the world if they were to fall.

Executives at the helm of Citigroup argued long and hard, over decades, for the ability to expand the scope of their business—breaking down the barriers between conventional commercial banking and all forms of financial transactions, including the most risky. In effect, the decline of the restrictions established by the original Glass-Steagall—at first gradual but ultimately dramatic—allowed Citigroup to increase the scale and complexity of gambles that it could take backed by deposits and ultimately backed by the government.

At its peak in 2008, Citigroup’s assets were around $2.5 trillion (under US Generally Accepted Accounting Principles (GAAP), which gives a relatively low estimate for derivatives’ exposure). We can call that over 15 percent of GDP. It was the largest bank in the United States and arguably the largest bank in the world. A large part of its business was—and remains—outside the United States, but there is no doubt that policymakers, here and abroad, felt that the US government was responsible for the havoc that the failure of Citigroup could wreak.

Citigroup had been in trouble before, for example on the back of loans to emerging markets made during the 1970s that went bad in 1982. But Citigroup was much smaller in the early 1980s—no more than a few percent of GDP—than it was in 2007. And the scope of its activities was much more limited. By the early 2000s, Citi had also become much more complex, with a presence throughout the financial system. And the opaqueness of derivatives meant that it was very hard for anyone—including the very smart people who run the Federal Reserve—to know how Citigroup’s losses could spread throughout the system.

Accounts of the financial crisis agree that the potential failure of Citigroup was viewed by policymakers as a major potential calamity to be avoided. As a result, a huge amount of official support was provided, directly and indirectly to keep Citigroup afloat. (For details, see Sheila Bair’s book, Bull by the Horns.)

Looking backwards, you could think of the 21st Century Glass-Steagall Act as a measure to unwind the structure that Citigroup would become.

But this misses the point of the legislation—and why this issue is now an urgent public policy priority. As a result of the crisis and the bailout measures put in place by both the Bush and Obama administrations, we have five groups of firms (with a holding company at the core) that resemble Citi in the run-up to 2007: JP Morgan Chase, Bank of America, Goldman Sachs, Morgan Stanley, and Citigroup itself. (And there are several other contenders for this status.)

All five of the firms contain some mix of boring traditional commercial banking, backed by insured deposits, and high risk activities—such as those inherent in investment banking and dealing in securities.

All of them are now undoubtedly too big to fail. And this creates exactly the kind of perverse incentives that prevailed at Citigroup. Excessive and mismanaged risk taking mean a few people get the upside when things go well, while the taxpayer and the broader economy get a crazy amount of downside risk.

Even Sanford Weill, former CEO of Citigroup who led the charge against the remnants of Glass-Steagall in the 1990s, concedes that this was a regrettable mistake—and argues for all of the biggest banks to be broken up.

Meanwhile, JP Morgan Chase is bigger today than Citigroup was at its largest. And executives at the biggest banks repeatedly demonstrate their willingness to use all the economic and political means at their disposal to bulk up even further.

The point of the New Glass-Steagall Act is to complement other measures in place or under consideration, including much higher capital requirements (both in the Brown-Vitter proposed legislation and in the new regulatory cap on leverage now under consideration), the Volcker Rule, and efforts to bring greater transparency to derivatives.

These measures are not substitutes for each other—they are complements. Each would be more effective if the others are also implemented properly.

Nothing can completely remove the risk of future financial crisis. Anyone who promises this is offering up illusions and deception.

But, like it or not, public policy shapes incentives in the financial system. We can have a safer financial system that works better for the broader economy—as we had after the reforms of the 1930s. Or we can have a system in which a few relatively large firms are encouraged to follow the model of Citigroup and to become ever more careless on a grander scale.

Also posted on Simon Johnson’s blog, Baseline Scenario.