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Glass-Steagall or Bank Size? Why Not Both, And More?

In the wake of JPMorgan Chase’s Fail Whale trade, proponents of stiffer regulation on Wall Street than what was ushered in with Dodd-Frank have offered a variety of solutions. In truth all of them could be beneficial in tandem to reduce risk and political influence from the financial system.

For instance, Elizabeth Warren, who has been vocal on this issue, just joined with the Progressive Change Campaign Committee to call for a reinstitution of Glass-Steagall:

Frankly, I don’t think we should just trust Wall Street banks to regulate themselves. Because as we learned during the 2008 financial crisis, they are not just taking risks with their own money — they are taking risks with the whole economy.

That’s why today, with the Progressive Change Campaign Committee, I’m calling on Congress to put Wall Street reform back on the agenda and to begin by passing a new Glass-Steagall Act. This was the law that stopped investment banks from gambling away people’s life savings for decades — until Wall Street successfully lobbied to have it repealed in 1999 […]

A new Glass-Steagall would separate high-risk investment banks from more traditional banking. It would allow Wall Street to take risks, but not by dipping into the life savings and retirement accounts of regular people.

Similarly, the Campaign for America’s Future took the opportunity to tout Sherrod Brown’s SAFE Act as a corrective to Wall Street’s unaccountable risk:

“The recent J.P. Morgan Chase debacle proves that financial markets do not self-regulate. They are given to excesses and to crackups. When banks are so big they assume government will bail them out, the excesses can be catastrophes. It’s time for the government to place sensible limits on the big banks,” said Borosage, “Sen. Brown’s SAFE bill is a good first step in insuring that banks are not too big to fail.”

Borosage added that with the nation’s six largest Wall Street banks controlling assets equal to 64 percent of U.S. GDP; the time for this safeguarding legislation is now.

Now, we can quibble about whether a new Glass-Steagall would really have worked to prevent the financial collapse of 2008, or whether cutting down bank size would end the spectre of too big to fail. One thing you see in both of these announcements is the idea that financial markets do not self-regulate. Left to their own devises, financial firms will take enormous risks. And since human beings habitually misprice risk, these will occasionally pan out badly. That’s when the implicit bailout subsidy kicks in. We need to end this assault on the taxpayer for a variety of reasons, and there are a number of ways to go about it.

Separating commercial and investment banks diffuses risk and ensures that bad investments don’t fall on the shoulders of the taxpayer. Banks can gamble with their own money anytime they want, they just can’t rely on an implicit bailout if they lose, socializing the risk and privatizing the profit.

The reason they have an implicit bailout is clearly a function of both size and political economy and influence, but also a function of being a bank, and having access to the discount window and other Fed goodies. Cut banks to a more discrete size cap, and push off the trading activities to a separate entity without these benefits, and you can eliminate the implicit subsidy. Then, if you have a credible FDIC-based system in place to wind down these now-smaller banks if they fail, you have more leeway to actually use it, rather than getting overruled into a bailout situation because the Treasury Secretary used to work with the CEO of the troubled firm.

And, if you put legitimate limits on leverage and serious capital requirements in place, you ensure that the bank has adequate reserves to cover their own losses, so we never get to the question of whether to use resolution authority or to bail out. Then you can end the conflicts of interest throughout the government and Wall Street and close the revolving door, which inevitably leads to bank-friendly solutions.

In other words, you set up a cascade of failsafes to protect the taxpayer and ensure that nobody pays for Wall Street’s bad bets but Wall Street. Dodd-Frank left a disturbing number of these policies on the table. In truth, you need as many of them as possible to succeed. This is the position of the number 2 at the FDIC, Thomas Hoenig, the conservative former head of the Kansas City Federal Reserve Bank.

Thomas Hoenig, vice-chairman of the Federal Deposit Insurance Corporation (FDIC), said in an interview with the Financial Times that broker-dealer activities should be cleaved off from banks, particularly large, systemic financial institutions.

Mr Hoenig, who for more than a decade has been warning of the dangers posed by large Wall Street banks, believes that trading operations should not be subsidised by US taxpayers through a bank’s access to emergency Federal Reserve funding and government-insured deposits […]

“In a crisis, who will absorb the loss?” Mr Hoenig asked, citing the bank bailouts that followed the demise of Lehman Brothers. He said that broker-dealer operations by their nature were laden with risks, with too little capital backing their activities. “It’s a leverage game,” Mr Hoenig said.

Hoenig hits almost every note in his remarks. As Warren says in her letter, “It has become clear over time — and made even clearer this past week — that additional Wall Street reforms are needed.” You can bat down one reform or the other, but the truth is a series of them are needed to wall off unproductive risk from wrecking the economy.

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David Dayen

David Dayen