A return of the Glass-Steagall Act has been suggested by US policymakers and commentators as a way to reduce risk in financial markets. This column argues that the legacy of separate commercial and investment banks actually made the crisis worse. Europe should not follow these proposals but should instead concentrate on strengthening the capital reserves of its banks.

The hurricane of the global financial crisis has been withstood – but it has left behind a swath of destruction in the US. The US devoted $1.3 trillion to rescue banks and $800 billion for economic stimulus packages. Private real-estate financing has completely collapsed – 95% of loans for private real-estate in 2009 were channelled through government institutions. More than 200 banks went bankrupt during the crisis. The US debt-to-GDP ratio will approach the 100% mark this year and will probably exceed it in 2011 or early 2012.

Now that the storm has subsided, it is time to clear away the debris from the shattered financial system. After initial hesitation, US president Barack Obama now seems ready to take action and is supporting the proposals of former Fed chairman Paul Volcker (Obama 2010).

Volcker has proposed reactivating the American system of separate investment and commercial banks that was created by the Glass-Steagall Act. The Act was established in 1933, shortly after the worst phase of the Great Depression, and it forbade commercial banks from acting as investment banks. The commercial banks were allowed to lend deposited savings to private households, businesses, and other banks, but they were not allowed to buy securities or to assist in their exchange. The purchase of stocks was forbidden, as was the acquisition of securitised financial products. Even the purchase of corporate bonds and private debentures was limited to a negligible minimum. The goal of the legislation was to protect savers from risky financial transactions.

When the Glass-Steagall Act was repealed in 1999, some commercial banks made hesitant attempts at investment banking, which gave rise to suspicions that this could have been a reason for the financial crisis. But this is far from the truth. In reality the system of bank separation remained fairly intact up to the outbreak of the crisis.

As is well-known, the crisis was triggered in 2008 by the unexpected failure of the government to rescue Lehman Brothers. That destroyed banks’ trust in each other and froze up the interbank market. Deposited savings could no longer be channelled to investors but stayed with the commercial banks. The result was a crash of the real economy. If the US had not had a separation of banks, the economy would have been less susceptible to a breakdown of the interbank market, since the commercial banks could have routed at least part of deposited savings to businesses via the purchase of stocks or bonds.

What motivated Obama and Volcker?

The answer lies in an event on 22 September 2008 that took the financial world by surprise, i.e. the conversion of Goldman Sachs and Morgan Stanley, the last surviving large investment banks, into normal commercial banks. Behind this conversion was the desire of the two banks to attain access to cheap credit from the Fed and the protection of Federal Deposit Insurance Corporation (FDIC). The government actually wanted to exclude the investment banks from receiving special help, but they got around this by quickly changing their legal status. Now Obama is trying to square up accounts.

This is understandable but dangerous for Europe because, unlike the US, it has a universal banking system. If Obama succeeds in anchoring a separation of commercial and investment banks worldwide at the G20 negotiations, this would mean a destruction of the European banking world, whereas in the US the repercussions of the reform would be limited. Hopefully Obama’s advisers were not inspired by this prospect.

Crisis prevention will certainly not come from a return to a system of bank separation. It is true that the reduced likelihood of government help will induce investment banks to act more cautiously. But this plus point does not offset the increased susceptibility to crisis from the division of banking functions. Moreover, it is doubtful whether the likelihood of government rescue will really be reduced. The state will have to rescue large investment banks even if they do not manage customer savings since no one would accept a repeat of the Lehman Brothers disaster.

The banks’ cavalier risk taking that led to the crisis was due to their inadequate capital reserves. People are tempted to gamble if their own capital is hardly involved, because they can pocket the gains and only have to shoulder a small portion of the losses themselves, regardless of whether the state helps or not. The incentive to gamble can only be suppressed by drastically increasing capital reserve requirements.

Europe should not follow the US proposals at the next G20 summit but should concentrate fully and entirely on strengthening the capital reserves of the banks.

Editor’s note: Note that this was first published as "Keine gute Idee", Wirtschaftswoche, No.6, 8 February 2010; republished in English with permission.

References

Obama, Barack (2010), “The “Volcker Rule” for Financial Institutions”, 21 January.