Put a lid on banks' risky business

Published Wednesday, November 11, 2009

Today marks a dubious anniversary of financial deregulation. Ten years ago, the Depression-era Glass-Steagall Act was repealed, removing the last legal barriers preventing commercial banks from engaging in the kinds of risk-taking and speculation of investment banks. That helped set the stage for the era of "too big to fail," and it's time to reimpose some regulation.

Glass-Steagall was passed in 1933 as part of the New Deal in the wake of thousands of bank failures. Commercial lending institutions were given federal deposit insurance and access to low-interest credit from the Federal Reserve. In exchange, they were barred from engaging in risky securities underwriting or stock ventures. To do so would be to gamble with their depositors' money and potentially taxpayers'.

With the end of Glass-Steagall, and all the other frenzied financial deregulation, greed took over. Once commercial banks, investment houses and insurance companies were allowed to merge, buy each other's products and compete for the same business, the potential profits from leveraging and risk-taking proved irresistible. It culminated in September 2008 when the failure of mortgage-backed securities laid bare the big bets and financial exposure of the banking sector. The credit markets froze and nearly brought down the economy.

Ten years ago a prescient Sen. Byron Dorgan, D-N.D., denounced the Financial Modernization Act that repealed Glass-Steagall. He called it "terrible" and said he wanted to "sound a warning call." But at the time he was nearly alone in his opposition. Larry Summers, a Treasury secretary under President Bill Clinton and now a senior economic adviser to President Barack Obama, cheered the death of Glass-Steagall as a boon to American competitiveness.

But since the economic meltdown, it has become clear that another version of Glass-Steagall is needed. Banks should have to choose: Stick to making standard loans and servicing customer investment accounts and have access to federally discounted money and insured deposits, or be an investment house with no taxpayer guarantees and the freedom to engage in brokerage activities.

Obama's economics team, including Summers, is opposed to such regulation. The administration seems to think that regulators looking out for systemic risks along with added capital requirements are enough to avoid another crisis. Congress also has little or no interest in reviving Glass-Steagall.

But Paul Volcker, the former Fed chairman who supports a new version of Glass-Steagall, has it right when he says trying to control risk with supervision rather than structural reform "just creates friction and difficulties."

One argument against a new Glass-Steagall is that it could put American banks at a competitive disadvantage against European banks. But the financial crisis tells us that the "too big to fail" model is devastatingly risky to an economy. In Britain, Mervyn King, essentially their Fed chairman, recently called for separating commercial banking from investment firms. That is what is needed here. Anything short of that will lead us back to another day of financial reckoning. You can bank on it.


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