The Big Bank Fix

Two alternative approaches dominate current discussions about banking reform: break-up and regulation. The debate goes back to the early days of US President Franklin D. Roosevelt’s “New Deal,” which pitted “trust-busters” against regulators.

In banking, the trust-busters won the day with the Glass-Steagall Act of 1933, which divorced commercial banking from investment banking and guaranteed bank deposits. With the gradual dismantling of Glass-Steagall, and its final repeal in 1999, bankers triumphed over both the busters and the regulators, while maintaining deposit insurance for the commercial banks. It was this largely unregulated system that came crashing down in 2008, with global repercussions.

At the core of preventing another banking crash is solving the problem of moral hazard – the likelihood that a risk-taker who is insured against loss will take more risks. In most countries, if a bank in which I place my money goes bust, the government, not the bank, compensates me. Additionally, the central bank acts as “lender of last resort” to commercial banks considered “too big to fail.” As a result, banks enjoying deposit insurance and access to central bank funds are free to gamble with their depositors’ money; they are “banks with casinos attached to them” in the words of John Kay.

The danger unleashed by sweeping away the Glass-Steagall barrier to moral hazard became clear after Lehman Brothers was allowed to fail in September 2008. Bail-out facilities were then extended ad hoc to investment banks, mortgage providers, and big insurers like AIG, protecting managers, creditors, and stock-holders against loss. (Goldman Sachs became eligible for subsidized Fed loans by turning itself into a holding company). The main part of the banking system was able to take risks without having to foot the bill for failure. Public anger apart, such a system is untenable.

Premature rejection of bank nationalization has left us with the same two alternatives as in 1933: break-up or regulation. Taking his cue from Paul Volcker, a former chairman of the US Federal Reserve, President Barack Obama has proposed a modern form of Glass-Steagall.

Under the Obama-Volcker proposals, commercial banks would be forbidden to engage in proprietary trading – trading on their own account – and from owning hedge funds and private-equity firms. Moreover, they would be limited in their holding of derivative instruments, and Obama has suggested that no commercial bank should hold more than 10% of national deposits. The main idea is to reduce the risks that can be taken by any financial institution that is backed by the federal government.

The alternative regulatory approach, promoted by Nobel Laureate Paul Krugman and the chairman of Britain’s Financial Service Authority, Adair Turner, seeks to use regulation to limit risk-taking without changing the structure of the banking system. A new portfolio of regulations would increase banks’ capital requirements, limit the debt that they could take on, and establish a Consumer Financial Protection Agency to protect naïve borrowers against predatory lending.

This is not an either-or matter. In testimony to the Senate Banking Committee in early February, MIT’s Simon Johnson endorsed the Volcker approach, but also favored strengthening commercial banks’ capital ratios “dramatically” – from about 7% to 25% – and improving bankruptcy procedures through a “living will,” which would freeze some assets, but not others.

Many details of the Obama package are unlikely to survive (if, indeed, the plan itself does). But there are powerful arguments against the principles of his approach. Critics point out that “plain old bad lending” by the commercial banks accounted for 90% of banks’ losses. The classic case is Britain’s Royal Bank of Scotland, which is not an investment bank.

The commercial banks’ main losses were incurred in the residential and commercial housing market. The remedy here is not to break up the banks, but to limit bank loans to this sector – say, by forcing them to hold a certain proportion of mortgages on their books, and by increasing the capital that needs to be held against loans for commercial real estate.

Moreover, many countries with integrated banking systems did not have to bail out any of their financial institutions. Canada’s banks were not too big to fail – just too boring to fail. There is nothing in Canada to rival the power of Wall Street or the City of London. This enabled the government to swim against the tide of financial innovation and de-regulation. It is countries like the US and Britain, with politically dominant financial sectors competing to take over financial leadership of the world, that suffered the heaviest losses.

This is the point that the well-intentioned regulators miss. At root, the battle between the two approaches is a question of power, not of technical financial economics. As Johnson pointed out in his Congressional testimony, “solutions that depend on smarter, better regulatory supervision and corrective action ignore the political constraint on regulation and the political power of big banks.”

Such proposed solutions assume that regulators will be able to identify excess risks, prevent banks from manipulating the regulations, resist political pressure to leave the banks alone, and impose controversial corrective measures “that will be too complicated to defend in public.” They also assume that governments will have to the courage to back them as their opponents accuse them of socialism and crimes against freedom, innovation, dynamism, and so on. In fact, this chorus of abuse has already started, led by Goldman Sachs Chairman Lloyd Blankfein.

There is another interesting parallel with the New Deal. Roosevelt got the Glass-Steagall Act through Congress within a hundred days of his inauguration. Obama has waited over a year to suggest his bank reform, and it is unlikely to pass. This is not just because the banking crisis in 1933 was greater than today’s crisis; it is because much more powerful financial lobbies now stand between pen and policy. If reformers are to win, they must be prepared to fight the world’s most powerful vested interest.