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If you’re younger than 90 and not a bank regulation groupie, there’s a good chance you didn’t understand why candidates participating in the Democratic presidential debate were making such a fuss about the Glass-Steagall Act.
The law, formally known as the Banking Act of 1933, changed the ground rules for Wall Street and shaped investor and saver behavior for decades. Should it be brought back, as several of the Democratic contenders suggested? How would a revised Glass-Steagall affect investors?
First, some history. The law, named after Sen. Carter Glass (D.-Va.) and Rep. Henry Steagall (D.-Ala.), was a populist response to rein in banks after the stock market crash of 1929 and the subsequent Depression. At the same time, it was an effort to restore trust in the banking system, which had experienced a wave of failures in which depositors lost their life savings.
To accomplish these aims, the law did two things: it split commercial banking (taking deposits and making loans) from investment banking (raising money for corporations and governmental entities by underwriting and selling stocks and bonds) and it created the Federal Deposit Insurance Corp., which put the federal government’s guarantee on bank deposits, creating a safety net for savers.
The legacy of the law lives on. Deposit insurance is still a reason people trust banks, and the splitting of commercial banking from investment banking is the reason there’s a Morgan Stanley in the stock and bond business and a J.P. Morgan Chase in the commercial banking business. (The law required giant banks to choose one form of banking or to split into independent entities, which is what happened to the House of Morgan.)
Among large nations, the U.S. was virtually alone in its split approach to banking, and by the 1980s and 1990s large U.S. commercial banks demanded that the law be repealed so they could better compete against large “universal” banks in Europe. Repeal came in 1999 to accommodate the creation of Citigroup, which combined the commercial banking activities of what had been the First National City Bank of New York and the non-banking activities of Commercial Credit Corp. and Travelers Insurance.
Critics of the elimination of Glass-Steagall say it fueled the “too big to fail” phenomenon, requiring the bailout of banks during the 2008 financial crisis. Defenders of the new regime say the financial world is too sophisticated and complicated now to go back to a regulatory environment suited for a simpler time.
Bringing back Glass-Steagall may help, but the real risk in the banking system — in the 1920s and now — is leverage. In the Twenties, the overleveraging occurred in margin loans on stocks, which Glass-Steagall eliminated by isolating margin debt in investment banks in order not to threaten deposit-taking and saving. Today, overleveraging takes place in the explosion of derivatives and a variety of complex “investment” vehicles that create daisy chains of debt. The fear in the 2008 crisis was that the collapse of Lehman’s massively overleveraged capital structure would bring down the world’s interrelated financial system.
Today, those risks remain despite Dodd-Frank and international requirements for bigger capital cushions at the big banks. And since those risks won’t abate until bank executives are personally on the hook for their risk decisions (the way that partners were in the days before financial firms were publicly owned), the global financial system will remain vulnerable to huge leverage-induced crashes.
Investors, therefore, should expect crashes to occur. Building a crash into long-term expectations can actually help improve investment performance over the long run by tempering the temptation to sell when the world looks like it is collapsing. Experience over many crashes shows that investors who keep their head during pre-crash euphoria and then hang on during the crash itself usually fare quite well in the long run as crash memories fade and more typical market and investor behavior returns.
Whether or not we get a new Glass-Steagall, anticipating the worst can help prevent the worst from destroying wealth.
Image courtesy of sixninepixels at FreeDigitalPhotos.net