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Reinstating Glass-Steagall Is a Really, Really Bad Idea

Having Glass-Steagall in place would not have prevented the last financial crisis. But reinstating it might make the next one even worse.

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In an effort to prevent a recurrence of the 2008 financial crisis, a group of senators, including John McCain, R-Ariz., and Elizabeth Warren, D-Mass., has introduced legislation to reinstate the Glass-Steagall Act, which enforced a division between commercial and investment banking. Despite the presumably good intentions of the bill's authors, Congress should reject their initiative. If this bill became law, it would do nothing to prevent another financial meltdown--and, in fact, it might make the next banking crisis even worse than the last one.

In some circles a myth has arisen: That the 1999 repeal of parts of the Glass-Steagall Act led inexorably to the 2008 financial disaster. Politicians like Rep. Walter Jones, R-N.C., often make the case that this repeal legislation, the Gramm-Leach-Bliley Act, allowed banks to "gamble with their depositors' money." In a blog post called "Let's Get Real," Sen. Warren clearly implies that if Glass-Steagall had been in place, the 2008 financial crisis would not have occurred. If true, these charges would be a damning critique of Glass-Steagall's repeal.

In reality, however, these claims do not withstand even a modest amount of scrutiny.

Although it is true that many banks bought excessive amounts of poor-quality, privately issued mortgage-backed securities, the repeal of Glass-Steagall did not enable these actions. Indeed, commercial banks were free to purchase private mortgage-backed issues prior to Glass-Steagall's repeal. As a young bank examiner in the early 1990s--well before Gramm-Leach-Bliley--I spent countless hours reviewing the documentation and projected cash flows for private-label mortgage-backed derivatives. (I was not then--nor am I now--very popular at cocktail parties.) In short, such poor investment decisions were possible with or without the repeal of Glass-Steagall.

Similarly, Glass-Steagall's repeal had no bearing on the exceptional risk-taking at Fannie Mae (FNMA) and Freddie Mac, both of which were bailed out by the federal government. Completely unrelated to Gramm-Leach-Bliley, both Fannie and Freddie increased purchases of risky, nonconforming loans at the same time they held relatively little capital. Indeed, according to the federal government's Financial Crisis Inquiry Report, Fannie and Freddie had $75 of assets for each $1 of equity, meaning that even a relatively small drop in the value of their mortgages could (and did) wipe out their capital. Blame greed, inadequate regulation, or some other factor, but the removal of barriers between commercial and investment banking did not affect Fannie and Freddie and were therefore not the cause of their decisions to maintain inadequate capital levels.

Nor is there evidence that diversified financial institutions, which were permitted by the repeal of Glass-Steagall, were more likely to experience financial turbulence than less-well-diversified firms. Indeed, the first institutions to experience financial stress in 2008 were the relatively undiversified investment banks that did not enter commercial banking, including Bear Stearns and Lehman Brothers. As such, the passage of Gramm-Leach-Bliley did not cause or even enable the problematic decision-making that afflicted Bear Stearns and Lehman Brothers.

Glass-Steagall's repeal also did not cause the large investment banks to take on excessive leverage. By 2008, many of the major investment banks, with the apparent assent of the Securities and Exchange Commission, had pushed their borrowing--much of it short-term--to stratospheric levels. For example, Lehman Brothers had more than $30 of assets for each dollar of capital. These investment banks did not incur mountains of debt because Gramm-Leach-Bliley rescinded rules that had separated investment and commercial banks. In fact, none of the large investment banks even entered into commercial banking, as the repeal of Glass-Steagall entitled them to do.

Nor is it true that the repeal of Glass-Steagall left regulators with inadequate tools to prevent the financial crisis. As the Financial Crisis Inquiry Report concluded:

"We do not accept the view that regulators lacked the power to protect the financial system. They had ample power in many arenas and they chose not to use it. To give just three examples: The Securities and Exchange Commission could have required more capital and halted risky practices at the big investment banks. It did not. The Federal Reserve Bank of New York and other regulators could have clamped down on Citigroup's excesses in the runup to the crisis. They did not. Policy makers and regulators could have stopped the runaway mortgage securitization train. They did not."

In addition to its near-certain failure to help prevent the next financial meltdown, the reinstatement of Glass-Steagall would hamstring regulators' efforts to deal with future financial crises. During the 2008 economic turbulence, the government provided bank holding company charters to a number of institutions, including  Goldman Sachs (GS) and  Morgan Stanley (MS). Simply knowing that these institutions could borrow money from the Federal Reserve gave investors more confidence in them, providing essential stability to their sources of funding. Moreover, when Merrill Lynch teetered on the brink of collapse, regulators arranged a shotgun marriage with  Bank of America (BAC). If Glass-Steagall's prohibition on combining commercial and investment banks had been in effect in 2008, these tools would have been unavailable to regulators--likely resulting in an even deeper economic downturn.

Simply put, if Glass-Steagall had been in place in 2008, it would not have prevented or even minimized the size of the financial crisis. Nor will it stave off financial crises in the future. In fact, it will likely make them worse. In recent sessions, Congress famously was less productive than at any time in modern history. Congress should do what it does best--nothing--when it considers this legislation to reinstate Glass-Steagall.

Scott Cooley is Morningstar's director of policy research and formerly served in a variety of analyst and management roles at the firm. He is also a graduate student at the University of Chicago, focusing on political science. Unless specifically indicated otherwise, the views that he expresses in this column are his own.

Scott Cooley does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.