The case for a Glass-Steagall ‘lite’

The case for a Glass-Steagall ‘lite’

By John Gapper

Since, by common consent, we are immersed in the worst financial crisis since 1929, it is not surprising some of the old remedies are being considered again. More baffling is how quickly one of them is being dismissed.

The Glass-Steagall Act was passed in 1933 in the New Deal reforms of Franklin Delano Roosevelt’s administration. The Act responded to scandals involving Goldman Sachs and National City Bank, and to a fear of JP Morgan’s overweening power, by splitting off investment banking from commercial banking.

On Friday, Paul Volcker, former chairman of the Federal Reserve, said the US could perhaps do with a new version of Glass-Steagall, this time splitting hedge funds, private equity funds and proprietary trading off from Wall Street banks such as Goldman Sachs and Morgan Stanley.

I heard Mr Volcker clearly since I happened to be sitting next to him at the time, on a financial panel convened by New York University’s Stern business school. His views are usually treated respectfully, given his role in curbing inflation in the 1980s, but Glass-Steagall is a tough sell.

“This is a complex issue, so it is surprising that some authorities are rushing to rule it out without publishing any analysis,” wrote Sir James Sassoon, who this week published a report on the future of financial regulation, in the Financial Times. Agreed – so here is mine.

Reinstating Glass-Steagall in its original form is a non-starter. Even if it were possible to split bank lending from securities underwriting – and the invention of securitisation makes that unlikely – there are sound reasons not to try. Apart from anything else it is useful to have banks, to buy insolvent investment banks.

This does not, however, mean that “too big to fail” financial institutions, ranging from Goldman and Citigroup in the US to Deutsche Bank, UBS and Royal Bank of Scotland in Europe, should be allowed to do whatever they previously did, now under an explicit government guarantee.

There are good arguments that they should be barred from proprietary trading and high-octane forms of asset management, including running hedge and private equity funds. Perhaps the fund management “buy side” should be entirely split from the investment banking “sell side”.

I am not sure about the second possibility. But, on the Obama administration’s principle that “a crisis is a terrible thing to waste”, it is wrong to jump from doubting the usefulness or practicality of reimposing Glass-Steagall to rejecting any such structural reform.

A reforming fundamentalist would consider reversing the City of London’s 1986 Big Bang, which ended the divisions between merchant banks, brokers and marketmakers and allowed US investment banks to take over the City. The former arrangement was quaint but had the virtue of curbing conflicts of interest.

Leaving this on one side, there are sound reasons to impose some kind of split between buy side and sell side in the financial services industry (in the US, Europe and elsewhere).

First, it would limit the size of the institutions that must be rescued when they get in trouble. As Ben Bernanke, Fed chairman, put it on Tuesday: “The belief of market participants that a particular firm is too big to fail has many undesirable effects.”

To minimise the financial risk to the taxpayer, it would help to set clear limits on the activities that such institutions undertake. The obvious thing to shed are fund management businesses that can be – and are – run perfectly well by non-banks.

Second, it would reduce some risks. That is obviously true of proprietary trading desks inside institutions such as Goldman, which take risks with the bank’s capital, and of their internal hedge funds.

It is arguably also true of hedge funds and private-equity arms run by these institutions’ asset management divisions. Bear Stearns and Goldman felt the need last year to save hedge funds they managed (the latter with greater success than the former), for fear of reputational damage.

Third, it would eliminate some glaring conflicts of interest. Many financial crises and scandals, such as the dotcom boom scandal over equity research being tailored to win investment banking business, are caused by such conflicts of interest.

The greatest conflicts in big financial institutions involve the blurring of boundaries between buy side and sell side, and the mingling of client funds with those of a bank or its employees. Shutting in-house hedge funds and trading desks would go a long way towards solving this.

Last, it would reduce complexity. Some big conglomerates (notably Citigroup) bought such a diverse and complex range of businesses that they became impossible to manage. A large commercial and investment bank is enough of a challenge without taking on asset management.

There are counter-arguments. One virtue of allowing large banks to own fund management divisions – the prime example being Swiss banks – is that the fees from private banking and asset management compensate for cyclicality in lending.

“Fee-based fund management is good for stability of earnings. Splitting these businesses off could have the perverse consequence of making banks riskier,” says Andy Kuritzkes, a partner of the Oliver Wyman strategy consultancy.

Even if governments allow banks to retain fund management arms, however, they should cast a beady eye over proprietary trading and fund management-style operations inside investment banks.

It is foolish to dismiss structural reform because Glass-Steagall no longer fits. If we instead have to rely on regulators to stop bad outcomes at complex and conflicted institutions, pity the poor taxpayer.