SMITH BRAIN TRUST — Democrats and Republicans are calling to reinstate a version of the Glass-Steagall Act, which from 1933 to 1999 separated investment banking (underwriting, issuing and distributing financial instruments like stocks and bonds) from commercial banking (deposit-taking and lending) activities. Are legislators about to “break up the big banks?”
“Reinstatement talk is driven largely by a presidential election like no other in modern history," says Professor of the Practice Clifford Rossi at the University of Maryland’s Robert H. Smith School of Business. “This includes an angry public on both ends of the political spectrum and subpar performance of the U.S. economy.”
Phillip L. Swagel, a UMD School of Public Policy professor and academic fellow with the Smith School’s Center for Financial Policy, says the current focus on Glass-Steagall is symbolic. “It’s something to propose more than to actually do,” he says. “For (Donald) Trump, it's a way to highlight (Hillary) Clinton as the candidate of Wall Street, as identified by Bernie Sanders. For the left, it positions them as ‘cracking down on big banks.’”
Rossi says bringing back Glass-Steagall in some form “would be a feel-good measure, much like the Dodd-Frank Act was post-crisis and would not attack the root of the banking sector's perennial issues.” Banking, he says, “operates in a cyclical environment, buffeted by boom and bust intervals that make placing their eggs in one basket a risky business.”
Bank profits are low, thanks to today’s low-interest rate environments, Rossi says. “So, having a more diversified revenue stream that includes investment banking can provide some counterbalance to commercial banking and vice versa as conditions shift.”
Swagel says there are more effective ways to ensure a safer financial system, notably by focusing on capital and liquidity requirements. “And it should be kept in mind that there is a tradeoff between regulation and growth,” he says. “Efforts to improve safety must be made with due consideration for the impacts on economic growth and job creation. Glass-Steagall falls short on this dimension.”
Ironically, adds Rossi, Glass-Steagall was repealed under Bill Clinton largely on the basis that it would improve competition and innovation in the banking sector.
Not a Financial Crisis Catalyst
Swagel reasserts his 2011 Congressional testimony that counters reinstatement proponents who suggest the repeal of Glass-Steagall spurred the 2008 financial crisis: “The end of the Glass-Steagall restrictions is not well correlated with the failures evident in the recent financial crisis. Bear Stearns and Lehman Brothers both failed, but these firms had remained investment banks. JPMorgan Chase, on the other hand, combined investment banking and commercial banking and yet weathered the strains of the crisis relatively well. The problems revealed by the crisis seem to be in the riskiness of the activities themselves—subprime lending, for example—and not in the combination of commercial and investment banking.”
On a fundamental level, Rossi says, “the issue surrounding Glass-Steagall, or the larger issue of ‘too big to fail’ isn't the combination or not of investment and commercial banking but rather the risk-taking of the institution.”
“The large banks in particular find themselves easy targets of politicians and policymakers in light of the abnormal risks taken by the industry leading up to the crisis,” Rossi says. “And in that sense, they very much brought on this scrutiny, helped in part by relatively lax regulatory oversight at the time.” This is the issue that politicians, policymakers and the public miss in this debate, he adds. “If the culture and infrastructure for taking and managing risk prudently were in place, it would ensure a stable banking environment without introducing unnecessary and sometimes detrimental regulation to the industry.
Place Risk-Taking in Crosshairs
Rossi says other policy approaches such as raising capital requirements on banks could be effective, but wouldn’t address the excessive risk-taking in the boom years by senior management and a general unwillingness to listen to risk managers. Rossi notes the Clinton campaign addresses this by proposing to introduce risk fees on the largest banks. The details, here, are not clear, he says. But a number of actions could be taken.
“First, regulators could create a bank risk index to assign robust risk-based deposit insurance premiums and capital requirements, he says. “Banks with poor risk culture, governance and infrastructure and taking on risky products and services would score low on the index and pay dearly in terms of deposit premiums and regulatory capital. Subsequently, companies offering directors and officers insurance could use such an index to price their premiums in a manner that incents banks to promote a healthy risk environment.”
“It is easy for politicians to throw out policy prescriptions that sound good at first glance, but this can have downstream effects that won't be known for years,” he says. “From the thrift crisis in the 1980s to the financial crisis of 2007-2008, the standard approach to bank policy has been to throw thousands of pages of regulation at the industry, wait for the inevitable credit crunch and economic downturn, then loosen regulation to spur economic activity.”
Bringing back Glass-Steagall, he says, perpetuates such a destabilizing regulatory environment. “Attacking the problem at its core by promoting and incenting every bank to manage its risk prudently has the best chance of bringing long-term stability to the banking sector.”
Opportunity for Risk Managers
Rossi, who saw the subprime meltdown from the inside of Citi, WaMu and Countrywide in senior risk management roles in those institutions authored “A Risk Professional Survivor’s Guide,” will further share his insight when he directs the Oct 31-Nov. 4, 2016 Enterprise Management Program. This executive training program takes place at the Reagan Building in D.C. and covers credit risk management, asset-liability management and business risk management. It’s co-presented by the Smith School and American Bankers Association. Rossi overviewed the program as keynote speaker for a recent ABA gathering.
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