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New bill splits investing, banking

By Claes Bell ·
Monday, July 22, 2013
Posted: 5 pm ET

Is splitting America's biggest banks down the middle the best way to prevent a future banking crisis? Some powerful voices in government and business seem to think so.

There's an effort underway in the Senate to revive the Glass-Steagall Act, a New Deal-era law that put a firewall between commercial banking, which consists of taking deposits and lending them out to consumers and businesses, and investment banking, which involves things such as underwriting stock offerings, assisting with mergers and acquisitions, and investing customers' and the bank's own funds in global markets.

"Glass-Steagall was put in place after the Depression because of the blowup in the banking environment," says Charles Kane, a senior lecturer at MIT's Sloan School of Management. "It was put in place to put up stop gates such that if things went really sour, there was an ability to block off the high-risk type of banking business from the traditional commercial banking business."

After being eroded in the '80s and '90s as regulators gradually expanded loopholes and increasingly allowed commercial banks to get into investing, the law was eventually repealed by the Gramm-Leach-Bliley Act with the blessing of former Federal Reserve Chairman Alan Greenspan.

"The argument that was pushed forward during Greenspan's time and even prior to that to get rid of Glass-Steagall was that in order for American banks to be as competitive as the other global banks like a Barclays or a Deutsche Bank,  we needed to have an ability to include investment banking activities with the commercial banking activities," Kane says.

Large commercial banks quickly snapped up investment banks and became huge players in international markets. That decision wasn't without consequences for the overall stability of the banking sector, says Kane.

"The problem with mixing investment banking with commercial banking is that investment banking takes on huge risks. There are huge risks that are taken with investment banks that would never pass muster on a 'putting capital at risk' criteria within a commercial bank," says Kane. "When an investment bank can leverage its capital be with the capital that the commercial side of the business accumulates, then you can make bigger bets on the investment side."

Sen. Elizabeth Warren, D-Mass., who championed the creation of the Consumer Financial Protection Bureau, as well as Sens. John McCain, R-Ariz.; Angus King, I-Maine; and Maria Cantwell, D-Wash., are leading the push for a Glass-Steagall revival, which they're calling "The 21st-Century Glass-Steagall Act."

"I know the 2008 financial crisis did not happen solely because the wall of Glass-Steagall was knocked down," McCain said in a floor speech before the Senate promoting the bill. "But I strongly believe the repeal of these core provisions have played a significant role in changing the banking system in negative ways that contributed greatly to the 2008 financial crisis, and I believe this culture of risky behavior is still in play."

Still, it's unlikely Glass-Steagall would have prevented the failure of the key institutions that touched off the crisis. Bear Stearns and Lehman Brothers, whose failure sent jolts through the international banking system, were purely investment banks, and many of the mostly commercial banks that failed did so because of bad decisions related to mortgage lending, a core role they would keep under Glass-Steagall.

"The things that blew up in 2008 were the instruments out there, the mortgage-backed securities and all the packaged debt that was pushed out and repackaged, and distorting the risk-return criteria," Kane says. "Would Glass-Steagall in its old form have prevented that from happening? I'm not sure it would."

Federal Reserve Governor Daniel Tarullo expressed a similar sentiment in a recent interview with Politico.

"Many of the institutions that actually provoked the most serious phase of the crisis were not within the commercial banking system at all, either individually or by affiliation," Tarullo said.

Kane says where Glass-Steagall might help is in limiting the damage of a crisis. "If (the collapse of Bear Stearns) was in a different time period when Glass-Steagall was in place, there would have been stop gates that wouldn't have made that as dangerous," he says.

For consumers, not much would really change. Commercial banks would still be able to provide financial advising services to customers and buy and sell stocks and other securities on their behalf.

But the bill would also involve taking a cleaver to some of the biggest and most recognizable names in finance, many of whom are agglomerations of prominent investment houses and banks -- in other words, no more JPMorgan Chase, Bank of America, Merrill Lynch or Citi Group.

Those companies would be forced to spin off their investment banking and commercial banking businesses into separate companies, drastically changing the landscape of the financial sector. Most of the top 10 banks by assets have sizable investment arms that would need to be, for lack of a better word, amputated.

That would ultimately put America's financial industry at a disadvantage compared to foreign banks that don't have similar limitations, Kane says.

In the end, Congress and President Barack Obama will have to decide if the downsides for the financial industry outweigh the chance to limit the damage of future crises.

What do you think? Should commercial banks be allowed to play the global market?

Follow me on Twitter: @ClaesBell.

Senior banking reporter Claes Bell is a co-author of "Future Millionaires' Guidebook," an e-book written by Bankrate editors and reporters. It's available at all the major e-book retailers

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September 27, 2013 at 7:01 pm

When will they ever learn?

I'm all for free market, until the free market begins to destroy the very society the feeds it.