Commentary - Would the Glass–Steagall Act Have Prevented the Recent Financial Meltdown?

The recent announcements by President Obama seem to have sent shivers down the backs of most banking executives, especially those who have worked extremely hard to assemble the giants of banking that we have today. An unintended consequence of the recent crisis has been the creation of banking giants that, unlike what many think, are even less likely to be allowed to fail. Just look at the institutions that JP Morgan and Bank of America have acquired, and the giants that they have become. If President Obama has his way they might have to divest the most lucrative parts of their businesses, the investment banking arms. If the European governments follow in his footsteps, Barclays Capital would soon have to fight its own battles without the financial might of its parent, Barclays Bank. The same goes for many of the other universal banks in Europe.

Few can deny that while the Glass–Steagall Act was in existence we did not witness any major financial meltdowns. So, it can certainly take a lot of credit for that. However, we certainly did not have a similar legislation in Europe and we did not experience any such crises in Europe either. In fact, while U.S. banks were being prohibited from owning investment banking franchises, their European counterparts were going through a feeding frenzy thanks to Mrs. Thatcher’s government’s liberalizations of the U.K. banking and financial system. Does anyone remember SG Warburg, De Zoete Wedd, Flemings, and the many other blue blooded merchant banks that were acquired by the major European and U.K. banks? Unless you are as old as I am and as interested in the old days of Jobbers and brokers you probably will not. But, the fact is that for over 30 years these institutions operated without any major crises.

Technology was, rightly or wrongly, blamed for the crash of October 1987, but not the merged enterprises. So, why is it that when the same legal environment is recreated in the U.S. the entire world thinks that the current crisis would not have happened had the Act not been repealed.

There is a lot to be said for preventing banks from becoming too big too fail, but that problem will not be solved by the separation of investment and commercial/retail banking. None of the banks that were rescued, with the exception of Goldman Sachs, would have been allowed to fail even if the Act was still in existence, for the mere fact that a huge chunk of U.S. homeowners, and not just the subprime borrowers, would have ended up on the streets.

The recent crisis was created not because investment banks were owned by retail banks. Lehman Brothers, Merrill Lynch, Bear Stearns, and Goldman Sachs were certainly not divisions of major commercial banking enterprises. It was created because securitization, despite all of its benefits in funnelling liquidity from locations that have excess capacity to those who need it, created an environment for unacceptable risk taking to take place. The fact that banks could move loans off their books and sell them to investors meant that they no longer needed to undertake the little due diligence that they used to when they had the loans sitting on their own books. Banks, and by that I mean retail not investment, simply moved from being aggregators of deposits to lend to borrowers to becoming financial engineers. Structuring mortgage pools and then selling them to investors. Their income was no longer equal to the spread between borrowing and lending, less the associated risk of default. It was now coming predominantly from structuring these deals. The risk of default was shifted to the investors who bought these securitized instruments. And, since their only appraisers were rating agencies, with no access to the quality of the underlying borrowers, they were incented to lend as much as they could to whoever they could persuade to borrow.

Separation of investment and retail banking would not have solved that problem. That is why we find that despite Deutsche Bank owning Morgan Grenfell for over 2 decades and experiencing no major crises it nearly collapsed thanks to investing in these types of AAA instruments. The list of German causalities is too long to mention, but none was facing problems due to the combination of investment and retail banking. The same goes for RBS.

There is a case to be made for a part of the Glass–Steagall Act that prevented U.S. banks from operating across states, which might have limited the scale of the problem, but even then foreign banks were pretty much exempt. Sir Fred Goodwin and his team would have happily taken up the slack.

Consequently, if we are to prevent future crises it will not be because we have reduced the size of banks from being too large to fail. These banks would have been rescued due to the systemic nature of the crisis. What needs to happen is for the banks that structure mortgage- and asset-backed securities to be forced to keep a good chunk of the obligation on their own books. So long as banks are forced to undertake due diligence, the kind of risks that were taken prior to the crash would be mitigated. The major implication would be the disappearance of many of the 100+ percent mortgages that are of no use to anyone but the kinds of speculators, and in many cases uncreditworthy, that have been keeping first time buyers off the property ladders.

It is time that the focus is turned to the main culprits of the current crisis and not those who were lucky enough to come out unscathed and, rightly or wrongly, able to pay their people bonus packages that are probably excessive.