It is Time for Reinstatement of the Glass-Steagall Act

Repeal of the Glass-Steagall Act in 1999 enabled investment and commercial banking arms of U.S. banks consolidate into bank holding companies. While the repeal maintained firewalls between investment and commercial banking arms of bank holding companies, it created a much larger problem that regulators either did not anticipate, or did not think would turn out to be as severe as it apparently has turned out.

In 2004, while a PhD Candidate at the RH Smith School of Business (Univ. of MD, College Park), I discussed with my Dissertation Supervisor how it was I thought repeal of the Act would backfire, would turn out harmful for capital markets. We discussed engaging on a research idea in respect of my intuition, but then I graduated in 2005 and we never did get around to it.

The issue I pointed out to my Dissertation Supervisor was my belief that given it would be bank holding companies as a whole that would be priced, profits from investment banking arms would be considered substitutes for profits from commercial banking arms. With bank holding companies publicly quoted, and with investors typically skittish for higher returns, bank holding companies likely would focus more on the bottom line than on their fiduciary responsibilities to society. It is important to note here that while commercial banks are private concerns set up to make money from lending activities, lending simultaneously has social welfare connotations, as such is considered a fiduciary responsibility of commercial banks. This is part of essence of oversight from the Federal Reserve.

Given fiduciary responsibilities that obtain within bank holding companies mostly are domiciled in context of commercial banking, possibility of abstraction from fiduciary responsibilities fit right into my intuition.

If there is easy money to be made within securities markets, there is less pressure to lend to businesses most in need of debt financing.

Add to chasing of quarterly profits introduction of securitization of bank balance sheets, a phenomenon which favors investment banking arms (firewalls are unable to prevent such benefits), yet simultaneously reduces dependence of commercial banking arms on management of their balance sheets, and it seemed clear to me bank holding companies ultimately would be bad for capital markets as a whole, and real sectors of economies.

As typically is the case, the rest of the world followed gladly on heels of the United States, resulting in massive deregulation of financial sectors all around the world. In Nigeria, between 2005 and 2007, many bank holding companies went public on profits from trading in securities markets. When stock markets crashed all over the world in 2008, stock prices of the banks crashed, and many Nigerians lost practically all of their savings because the lending business was a significantly small proportion of aggregate bank holding company business. Investors in Iceland suffered a similar fate as investors in Nigeria.

This of course is illustration of ‘bad’ essence of bank holding companies.

Fifteen years down the road, with several financial meltdowns in tow, my intuition has proved right. Post the 2007 meltdown and with bail out money from government in tow, commercial banks would not lend money. Nothing the U.S. Government tried worked.

Why?

Investors seeking to recoup losses on their portfolios needed investment banking even more, meaning bank holding companies could continue to do well on back of investment banking business. With severity of uncertainty about state of the economy as their excuse, and with investment banking profits in tow, commercial banking arms of bank holding companies were not under any real pressure to lend money.

In absence of the bank holding structure, commercial banks would have had to lend out money in order to turn good profits, would have had to take some risk, the economy would not have stagnated quite as much as it turned out post bail out.

In the mean time, bank holding companies have made odes of money post 2007. Consider, however, that several notable studies by eminent scholars in realm of Finance/Financial Economics have demonstrated quite clearly that unrestrained value maximization implicit in introduction of bank holding companies is sub-optimal not only for the entire society, but also for shareholders of firms that choose value maximization over Pareto optimality of investment decisions.

These studies are Stiglitz (1972), Jensen and Long (1972), and Leland (1973).

The intuition here is, value fluctuations induced by unrestrained value maximization ultimately and over long horizons yield average outcomes that are dominated by much smaller fluctuations which are outcome of focus on Pareto optimality, that is focus on value optimization, with optimization embedding focus on welfare of all stakeholders, as opposed to shareholders alone.

Unrestrained value maximization induces risk levels that ultimately are sub-optimal for society, resulting in cycles of booms and busts, as opposed to steady, sustainable growth.

Booms and busts induced by trading in securities tend to be more severe than booms and busts induced within real sectors of an economy.

In case of the banks, the government bailout in essence mitigated low profitability outcomes that ought to have dissuaded focus on investment banking over commercial banking, with outcome the banking system today remains almost as frail as it was back in 2007.

In addition to inducement of greater health within capital markets, reinstatement of the Glass-Steagall Act will create new jobs within the financial and real sectors of the U.S. economy.

This outcome is guaranteed to be the case because repeal will increase competition within each of the investment banking and commercial banking spaces.

While the U.S. economy has steadily been creating jobs, it is known for a fact that there are not quite as many full time professional jobs being created. In presence of greater competition for business within commercial and investment banking sectors, real sectors of the economy reap benefits.

Altogether, reinstatement of the Glass-Steagall Act is in the best interests of the U.S. economy and should be emulated all over the world.

If the political will is there, it is time for reinstatement of the Glass-Steagall Act.