Wednesday, December 8, 2010

Bank Size

FLG was surprised by this Room for Debate on the size of banks. Only one contributer argued in favor of reinstating Glass-Steagall, but that was "Nomi Prins...a senior fellow at Demos" -- no surprise somebody from Demos would make that argument. And no surprise that FLG ignored it just as quickly. Although, in fairness, she was a managing director at Goldman at some point.

On the other hand, Jeremy Stein, a professor from Harvard, writes:
The Glass-Steagall issue in particular strikes me as a red herring; I know of no hard evidence to suggest that the combination of traditional lending and investment banking services such as stock and bond underwriting has destabilized the financial system.

In any case, she was the only one who argued for Glass-Steagall, which goes to show that this idea was always a bit flaky. In fact, FLG can't remember anybody making a serious economic argument about why the repeal Glass-Steagall was a problem. It was always a sort of correlation equals causation or it was better before type argument. Prins' argument is no different:
Before Glass Steagall was repealed in 1999, the top five banks held 19.5 percent of national consumer deposits. Today,they hold 40 percent.

But that's not about investment banking versus commercial banking. The more likely cause is the relaxation of interstate banking, which began in 1994 with the Riegle-Neal Act and was only fully implemented with the Gramm–Leach–Bliley Act in 1999, which also happens to be what repealed Glass-Steagall. Seriously, customer deposits doesn't really have much to do with this investment banking versus commercial banking stuff because it only deals with one side of it, the commercial banking, which is FDIC insured anyway. Moreover, FLG contends that the repeal of Glass-Steagall helped in the crisis because commercial banks were able to buy the investment banks before they failed.

Prins concludes her argument thusly:
Glass-Steagall was designed to prohibit the risk of speculative, bonus-driven practices from eradicating the hard-earned money of ordinary citizens. By not allowing our riskiest banks to go bankrupt when they were at the financial abyss, and not deconstructing their merged nature, while following a policy of pumping up asset and Treasury prices, we have already failed to stop the next stage of this crisis.

This is just confused. Lehman Brothers, a pure investment bank, meaning it would have been able to exist under Glass-Steagall rules, failed and it almost brought the system down. Therefore, FLG isn't quite sure how separating them protects the system.

The simple fact is that new financial products, including derivatives, possess qualities that are hybrids of the old products and make it difficult to separate risky from non-risky activities. For example, it's easy to see how a commercial banking could use interest rate swaps or currency futures to hedge interest rate and foreign exchange risk quickly, cheaply, and easily. It's also easy to see how they could use those to speculate. Problem is that there's no bright line where one cross over from one to the other, at least from looking at the accounting data. And so even if it would be desirable to go back to Glass-Steagall principles, FLG isn't at all convinced it's even possible given technological innovation and the concomitant financial innovation.

So, FLG is still waiting for somebody to make a logical case for why going back to Glass-Steagall is 1) the right thing to do and 2) actually possible. (And FLG doesn't mean politically possible, he means that given financial innovation how it becomes literally possible to cordon off speculative activities.) Until now FLG has heard this recommendation from numerous people, almost always on the Left and almost always without any real economic training or even insight. Sure, there's been a couple of people who worked in investment banks who've made this argument, but it's surprising how little insight into the financial system they offer. When you really boil it down, their objection is usually a moral one against the culture of Wall Street, not an argument about the operations of the financial system.


The Ancient said...

I'm completely unmoved by the arguments about size per se. If we feel the need to put further constraints on risk taking (and we do and should), by far the best way is to force bankers to put their own economic lives on the line every day. They should always be the first to bear any adverse consequences of their decision-making -- not only in their pay but also in their personal assets.* (Hmmm. Did I just say the world should be even more like Goldman Sachs?)

P.S. You need a new label for these sorts of posts. How about Herrings From The Reds?
*Under a proper regulatory regime, Dick Fuld and his ilk would be bankrupt.

FLG said...

Michael Lewis argued that banks shouldn't be public companies, they should all be partnerships, like they were before. Seems like a reasonable way to get incentives right. But how to get from here to there?

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