Hollywood knows nostalgia sells. That’s why cineplexes are stuffed with sequels, remakes, and reimagined versions of 1960s TV shows. But can Washington use nostalgia to break up America’s megabanks? Senators John McCain and Elizabeth Warren are giving it a shot. The Arizona Republican and Massachusetts Democrat last week unveiled their “21st-Century Glass-Steagall Act,” which would restore the barrier between commercial banking and investment banking first established by the Banking Act of 1933. That prohibition, known as the Glass-Steagall “wall” after congressional sponsors Senator Carter Glass of Virginia and Representative Henry Steagall of Alabama, was repealed by the Financial Services Modernization Act of 1999, legislation signed by President Bill Clinton.
McCain and Warren, through both the title and substance of the bill, are playing off the widespread public belief that the repeal of Glass-Steagall was a monumental mistake, effectively ending seven decades of financial calm and contributing greatly to the Great Recession and Financial Crisis. So it follows, at least according to McCain and Warren, that bringing back Glass-Steagall would go a long way toward returning us to that post-Depression era of stability and finally ending Too Big to Fail.
As McCain puts it, “Since . . . shattering the wall dividing commercial banks and investment banks, a culture of dangerous greed and excessive risk-taking has taken root in the banking world.” And Warren says the bill would “make our financial system more stable and secure, and protect American families.”
But would it? Nostalgia can be misleading, like peering through a glass darkly. America’s long stretch without a major financial crisis also coincided with a post-war boom driven by a temporary and unsustainable position of global dominance over recovering Europe and the command-and-control economies of Asia. And even while Glass-Steagall was law, the U.S. financial system faced several severe shocks, including the Latin-American debt crisis, the savings-and-loan crisis, the 1987 stock-market crash, and the collapse of the hedge fund Long-Term Capital Management.
Then came the 2007–2009 meltdown, but it’s hardly obvious the Glass-Steagall repeal was to blame. Certainly a direct causal link is tough to find. Both Bear Stearns and Lehman Brothers were investment banks that failed, while JP Morgan — both a commercial and investment bank — weathered the storm. And if Glass-Steagall’s mandated separation between commercial and investment banking still existed, the big commercial banks couldn’t have absorbed Bear and Merrill Lynch — nor could Goldman Sachs and Morgan Stanley have converted themselves to bank holding companies.
But Glass-Steagall’s demise was hardly a non-event. As financial reporter Charles Gasparino has argued, when financial giants such as JP Morgan and Bank of America became oversized financial supermarkets, it nudged investment banks such as Bear, Lehman, Morgan Stanley, and Goldman Sachs to take bigger risks to compete. Economist Luigi Zingales thinks Glass-Steagall helped restrain Wall Street’s political power by giving commercial banks, investment banks, and insurers competing policy agendas. “But after the restrictions ended,” Zingales wrote in the Financial Times, “the interests of all the major players were aligned.” So when the financial crisis hit, Washington got the same collective, pro-bailout message from Manhattan. The megabanks spoke with one voice.
Daniel Tarullo, the Federal Reserve governor who handles the central bank’s regulatory brief, has been cautious about similar Glass-Steagall proposals, saying that “with the present state of research, it is virtually impossible” to do a proper cost-benefit analysis of reinstating the wall. Another option, one suggested by Thomas Hoenig of the Federal Deposit Insurance Corporation, is to continue to let commercial banks underwrite securities, but broaden and strengthen Dodd-Frank’s “Volcker Rule” by banning commercial banks from all trading, market making, and involvement with complicated financial derivatives such as collateralized debt obligations, products central to the subprime-mortgage meltdown. In addition, legislators and regulators might want to consider a nostalgic look back to the equity-capital levels of the pre–New Deal, pre-Fed banking system, several times higher than current requirements.
But whatever the exact fix, the McCain-Warren bill, along with a bank-overhaul proposal from Senators Sherrod Brown, an Ohio Democrat, and David Vitter, a Louisiana Republican, is a sign that Washington increasingly sees Dodd-Frank as the beginning rather than the end of broad financial reform. And now it might be time for a sequel.
— James Pethokoukis, a columnist, blogs for the American Enterprise Institute.