Former Federal Reserve Chair Ben Bernanke (Photo Credit: AP Photo/Manuel Balce Ceneta, File)
At a Politico speaking engagement promoting his new book in October, former Fed chairman Ben Bernanke stated that he was “a little puzzled" by Democratic presidential candidates Sen. Bernie Sanders and Gov. Martin O'Malley at October's Democratic debate placing emphasis on reinstating the Glass-Steagall Act, a Depression era law that would separate commercial and investment banking activities, in order to promote financial stability.
Indeed, the law became a major point of discussion again in November's Democratic debate as several candidates highlighted the need to "break up the big banks".
Repealed in the 1999 by the Gramm-Leach-Bliley Act, Glass-Steagall has been a centerpiece law held up by many Democrats who unequivocally demand more regulation for banks. However, without giving enough thought, it’s easy to lose sight that not all regulations are helpful in improving financial stability and that many can be counterproductive to achieving this goal.
Glass-Steagall was irrelevant to the financial crisis since it would not have affected the investment banks and commercial lenders that were distressed in 2008
First, Glass-Steagall would have been “irrelevant”, to quote Bernanke, in preventing the 2008 financial crisis since commercial banks like Wachovia or Washington Mutual went bad because they made bad loans, and investment banks like Bear Stearns and Lehman went bad because of their investment banking activities.
Similarly, Glass-Steagall would have had no effect on AIG, a massive insurance giant and not a bank, which required large repeated bailouts during the crisis.
The “big banks” like J.P. Morgan and Bank of America, which Glass-Steagall would effectively break up, were in fact relatively solvent compared to their pure investing banking or commercial lending counterparts during and after the crisis with the one possible exception of Citigroup.
Glass-Steagall would have prevented the big banks from acquiring the distressed investment banks which stabilized the financial system in 2008
Second, one could make the argument that had Glass-Steagall been in place, it would have made the financial crisis worse as it would have prevented large banks like Bank of America or J.P. Morgan from ultimately buying the distressed Merrill Lynch or Bear Sterns respectively, acts which ultimately helped quell the financial contagion of 2008.
Without prospective buyers, those investment banks could quite possibly have followed the same liquidation fate of Lehman Brothers, creating an even larger systemic issues for their counterparties.
Bernanke argues that re-implementing Glass-Steagall "would just be an example of breaking up firms for the purpose of breaking them up without a clear rationale for doing that.”
Clear, transparent risk-weighted capital requirements would do more for the financial system than Glass-Steagall
Third, the implementation of Basel III risk-weighted capital requirements instead would do a much better job of keeping banks safe and without a need for taxpayer bailouts than blindly breaking up financial institutions as Glass-Steagall would.
Recent research from University of Chicago professor Luigi Zingales suggests that capital requirements can help solve the problem of “Too Big Too Fail” by ensuring that large financial institutions keep a large enough equity capital cushion so they will not default on either their deposits or their derivative contracts in the event of a panic. Effectively, this would help prevent the need for future bailouts at that are paid for by the taxpayer.
However, Zingales’ research highlights that not all new banking regulations are good ones brought, as many are often brought forth at the lobbyists to improve their bottom-line but not enhance consumer surplus, a process which has come to be known as “regulatory capture”.
Zingales’ research further demonstrates that without the right kind of rules, finance can easily degenerate into a “rent‐seeking activity” where banks become less competitive by creating regulatory barriers to entry, in turn making themselves more systemically important.
Bernanke in his recent speech has further highlighted that as a consequence of capital requirements that “banks are now evaluating their own size and complexity in light of the fact that on the one hand, there are economic benefits to size, but on the other hand, it's becoming much tougher to be a big bank”.
Indeed, larger banks “are trying to shrink” because they do not want to hold as much regulatory capital on their balance sheets that is now required of the largest institutions.
Glass-Steagall on the other hand is a mere relic of the New Deal era that would not do much for financial stability other than to make it less sound. Liberal economists who have championed other forms of financial reform such as Alan Blinder and Paul Volcker acknowledge these challenges with reinstating the Depression era law.
Dodd-Frank erroneously uses a leverage ratio instead of risk weights in creating bank capital requirements
Instead, we need financial regulations like capital requirements that are transparent, straightforward and risk-weighted (not based on a plain leverage ratio as Dodd-Frank has done which treats C-rated bonds the same way as overnight repos). Despite however well intentioned to reduce risk in the financial system, the Dodd-Frank Act has made the big banks even larger and less competitive through the systematically important financial institution (SIFI) designation, resulting in only two new banks being started in America since 2010.
In addition, Dodd-Frank has created increased regulatory uncertainty through creating an even larger bureaucracy of ill-defined institutions such as the Consumer Financial Protection Bureau (CFPB) that still lack a clear scope of their mandate or explanation of how their powers will be used.
Once we acknowledge the key challenges with Dodd-Frank (which is not entirely flawed), only then can we start talking about meaningful financial reform that will be effective in creating financial stability and ending "Too Big To Fail".
