The Return of Glass Steagall (Part 2)

So how might this new form of Glass Steagall emerge? 

Under the Dodd Bill in the Senate Banking Committee and under the derivatives bill adopted by the Senate Committee on Agriculture, commercial banks would have some serious limits on their securities activities.

The Dodd Bill contains the "Volcker Rule."  Section 619 would prohibit proprietary trading by banks.  As the Senate Report describes:  

• Section 619 of Title VII prohibits or restricts certain types of financial activity -- in banks, bank holding companies, other companies that control an insured depository institution, their subsidiaries, or nonbank financial companies supervised by the Board of Governors – that are high-risk or which create significant conflicts of interest between these institutions and their customers.

• Banks, bank holding companies, other companies that control an insured depository institution, their subsidiaries, or nonbank financial companies supervised by the Board of Governors will be prohibited from proprietary trading, sponsoring and investing in hedge funds and private equity funds, and from having certain financial relationships with those hedge funds or private equity funds for which they serve as investment manager or investment adviser. A nonbank financial institution supervised by the Board of Governors that engages in proprietary trading, or sponsoring or investing in hedge funds and private equity funds will be subject to Board rules imposing capital requirements related to, or quantitative limits on, these activities.

The Senate Report viewed the transactions as excessively risky.

• The incentive for firms to engage in these activities is clear: when things go well, high-risk behavior can produce high returns. In good times these profits allow firms to grow rapidly, and encourage additional risk-taking. However, when things do not go well, these same activities can produce outsize losses.

• When losses from high-risk activities are significant, they can threaten the safety and soundness of individual firms and contribute to overall financial instability. Moreover, when the losses accrue to insured depositories or their holding companies, they can cause taxpayer losses. In addition, when banks engage in these activities for their own accounts, there is an increased likelihood that they will find that their interests conflict with those of their customers.

• The prohibitions in section 619 therefore will reduce potential taxpayer losses at institutions protected by the federal safety net, and reduce threats to financial stability, by lowering their exposure to risk. Conflicts of interest will be reduced, for example, by eliminating the possibility that firms will favor inside funds when placing funds for clients. The prohibitions also will prevent firms protected by the federal safety net, which have a lower cost of funds, from directing those funds to high-risk uses. Moreover, they will restrict high-risk activity in those nonbank financial firms that pose threats to financial stability.

• The prohibitions also will reduce the scale, complexity, and interconnectedness of those banks that are now actively engaged in proprietary trading, or have hedge fund or private equity exposure. The will reduce the possibility that they will be too big or too complex to resolve in an orderly manner should they fail.

Thus, commercial banks will not be able to engage in proprietary trading.  Presumably the profits that can be made from proprietary trading will encourage some commercial banks to give up their deposit taking activities in favor of investment banking. 

Similarly, the Agriculture Committee just adopted the The Wall Street Transparency and Accountability Act of 2010.  Section 106 of that Act provides that swap entities (defined as swap dealers and major swap participants) cannot receive funds from the federal government, whether funds from the Federal Reserve or funds from deposit insurance.  As the Summary of the Bill describes, the "section prohibits federal assistance (including federal deposit insurance, and access to the Federal Reserve discount window) to swaps entities in connection with their trading in swaps or securities-based swaps."

This is no small segment of the financial markets.  According to one report, the major dealer banks generated approximately $30 billion in revenue from derivative transactions.  The study (n. 39) notes that the top five of the 25 bank holding companies account for 96-97% of the derivative trades by these holding companies (based upon data from Office of the Comptroller of the Currency).  The top 5?  JPMorgan Chase, Goldman Sachs, Bank of America, Citibank and HSBC.  

What is likely to happen if both of these reforms pass?  Some of the dealer banks (Goldman, for example) will likely give up on deposits and effectively return to its prior status as investment banks.  Those wanting to remain deposit taking entities will have to spin off their derivatives function, much the way the commercial banks had to spin off their securities functions in the aftermath of Glass-Steagall.  See Of Brokers, Banks and the Case for Regulatory Intervention in the Russian Securities Markets at 235-237 (discussing impact of Glass-Steagall as mechanism for preventing commercial bank domination of securities markets).  

Whether this form of Glass-Steagall will be sufficient to create a class of intermediaries that can ensure the vibrancy of the securities markets remains to be seen.  Nonetheless, it will be an unanticipated but beneficial effect of the current efforts at securities reform. 

http://ag.senate.gov/site/ComLeg/WSTAA%20Section%20by%20Section.pdf

Comments

[The real Glass Steagall]

The so-called "Volcker Rule" is nothing but a psuedo-Glass-Steagall attempted on behalf of President Obama and the British-run inter alpha group to divert action within our country away from the McCain/Cantwell amendment 3884 in the Financial Stability Act of 2010. Any true patriot will support this measure or suffer the consequences that their inaction will bring upon the United States, and the world. Future generations will never forgive us if we fail to act, now! Pass the Finacial Stability Act of 2010, complete with the McCain/Cantwell amendment 3884.