The Return of Glass Steagall (Part 1)

One of the mistakes made in the anti-regulation era was the decision to repeal Glass-Steagall.  Glass-Steagall separated commercial banking (deposit taking) from investment banking (underwriting).  It was a vestige of the Great Depression when commercial banks were punished for the country's economic collapse and were required to divest themselves of their investment banking functions.  

Until Glass-Steagall, the commercial banks had been taking over the underwriting business, squeezing out brokers.  See Of Brokers, Banks and the Case for Regulatory Intervention in the Russian Securities Markets, at 235 (noting that at onset of Great Depression, eight commercial banks controlled half of all underwriting).  This was no accident.  The commercial banks had a number of inherent advantages, including size and the extra capital layer that came through the attraction of deposits.  Had Glass-Steagall not come along, there would have been no more independent investment banking firms of any significant size. 

Glass Steagall, however, walled off the commercial banks from most securities activities.  This allowed a class of investment banks to develop and prosper.   Moreover, they were committed to active and innovative securities markets.  It was, after all, how they made their money.  

With the repeal of Glass-Steagall, investment banks as free standing financial intermediaries were destined to disappear.  That inevitability was discussed in The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.  Commercial banks simply had too many advantages.  As lenders, they had close relationships with corporate America.  As deposit taking institutions with wide networks of branches, they had a low cost supply of funds.  These advantages meant that over time they would take over the securities business previously controlled by investment banks. 

Investment banks also had a history of greater risk taking.  This meant that sooner or later most investment banks would take too much risk.  Unlike commercial banks, they lacked the liquidity protection provided by the Federal Reserve Board.  Inevitably, as the collapse of Lehman Brothers shows, investment banks would have a more difficult time surviving any financial crisis than commercial banks.

This largely came to pass during the financial crisis.  Three of the big five investment banks disappeared, either by failing or through purchase by a commercial bank (Bear, Merrill & Lehman).  Only Goldman and Morgan Stanley survived, although both converted to commercial banks. 

What difference does it make?  Commercial banks are less dedicated to the capital markets.  If a company needs funding, banks would often prefer a lending relationship to the sale of securities (whether stock or bonds).  As a result, they were in a position to discourage use of the capital markets in favor of a direct lending relationship. 

The only way to prevent commercial bank domination of the securities markets is to again separate some or all aspects of commercial banking from securities activities.  This has been suggested from time to time but is unlikely to occur.  Nonetheless, in the current reforms for the financial markets under consideration, there is at least a possibility that Congress will again separate some aspects of commercial banking and securities functions, allowing for the development of a separate class of free standing investment banking firms that are oriented towards the securities markets. 

Those reforms will be discussed in the next post.