Banks have seen both record profits this year and an unprecedented flurry of new regulations they say could threaten that prosperity.
The list of reforms includes new capital requirements, restrictions on derivatives trading, new requirements for money market funds, and reporting on social media communications for brokerages, just to name a few.
It is an idea that has reared its head in the Senate, however, that could bring the biggest change to banking since the industry collapsed in 2008. The idea, introduced by Senators Elizabeth Warren (D-Mass.), John McCain (R-Ariz.), Angus King (I-Maine), and Maria Cantwell (D-Wash) is to bring back the Glass-Steagall Act, which would separate traditional banks, with savings and checking accounts that are insured by the Federal Deposit Insurance Corporation, from riskier financial institutions that offer services such as investment banking, insurance, swaps dealing, and hedge fund and private equity activities.
The 21st Century Glass-Steagall Act, a modernized version of the Banking Act of 1933, goes well beyond the restrictions of the original regulation and would also dwarf the prohibitions of the Volcker Rule, a pending component of the Dodd-Frank Act that would bar banks from proprietary trading.
The bill includes, for example, measures to keep banks from simply adding a technical partition between commercial and investment banking operations. According to the bill, any individual who is an officer, director, partner, or employee of any securities entity, insurance company, or swaps entity could not serve at the same time as an officer, director, employee, or other institution-affiliated party of any insured depository institution.
Critics of plans to wind back deregulation of the banking industry say the genie could be difficult to put back in the bottle. “Proposing to go back to Glass-Steagall is analogous to proposing to solve global warming by outlawing cars and going back to horses and buggies,” says Gary Gorton, professor of finance at the Yale School of Management. He calls the measure, “a distracting, populist rally cry.”
The bill would, over a five-year transition period, separate depository institutions from products that did not exist when Glass-Steagall was originally passed, such as structured and synthetic products including complex derivatives and swaps.
“Despite the progress we've made since 2008, the biggest banks continue to threaten the economy,” said Sen. Elizabeth Warren in a statement, citing a statistic that the four biggest banks are now 30 percent larger than they were just five years ago.
There are key differences between the old Glass-Steagall Act and the modern variation, says King, the senator from Maine. These changes are intended to eliminate past loopholes.
The new bill narrowly defines the meaning of “the business of banking” and “closely related activities” to make explicit what activities insured depository institutions will be allowed to engage in, he explains.
“It also recognizes that since passage of the original bill, new kinds of financial products and institutions have emerged that have added to the complexity and risk in our financial system,” he says. The bill separates insured deposit institutions from “the modern, risky financial services and bans them from owning or investing in institutions like hedge funds or private equity funds.”
Proponents also upped the enforcement ante. Attempts to evade its restrictions can be met with fines as extensive as10 percent of the entity's net profits, averaged over the previous 3 years
Throwback Regulation
The original Glass-Steagall legislation was introduced in response to the financial crash of 1929 and separated depository banks from investment banks. In 1999, after 12 attempts at repeal, Congress passed the Gramm-Leach-Bliley Act to repeal the core provisions of Glass-Steagall.
Since then, “a culture of excessive risk taking has taken root in the banking world,” McCain said in a statement. His proposal may not end “too-big-to-fail,” he admitted, but it would “rebuild the wall between commercial and investment banking that was in place for over 60 years.”
Proponents of the regulation say the reform is needed to prevent another meltdown in the banking industry. “The problems created by the repeal of Glass-Steagall will eventually require that we pass this bill,” says former Senator Ted Kaufman, who served as chairman of the Congressional Oversight Committee of the Troubled Asset Relief Program (TARP). “The question I have is how much damage we do to the economy before we do that.”
“The problems created by the repeal of Glass-Steagall will eventually require that we pass this bill. The question I have is how much damage we do to the economy before we do that.”
—Ted Kaufman,
Former Senator,
Delaware
Unfortunately, despite the best efforts of the Dodd-Frank Act to ensure transparency, banks are still finding ways to get around regulatory restrictions, Kaufman says. “We have our banks, with all this FDIC insurance, up to their eyeballs in these derivatives and the market is not being regulated,” he says. “The chances that something bad can happen are pretty high.”
During his recent appearance before the Senate Banking Committee Federal Reserve Chairman Ben Bernanke steered clear of endorsing a return of Glass-Steagall, but he did say he still had some concerns about banks taking on too much risk. He also pointed to efforts to mitigate the systemic risks posed by big banks needing government bailouts. New capital requirements and mandated stress testing, to ensure that institutions can weather a 2008-like drop in asset values, are important, he said. He also stressed that many in Washington are “working hard to put the Volcker Rule into place.”
A Stronger Volcker Rule, Instead?
The proposed bill is certain to renew a push for, and debate over, the Volcker Rule, a long-delayed cornerstone of the Dodd-Frank Act that places limits on proprietary trading by banks, except for the permissible activities of hedging, market making, and underwriting. It would also limit the ability of banks to own hedge funds and private-equity funds.
“The Volcker Rule is supposed to limit banks from taking risks with their own money,” says King. “While that rule is a good start, it is in the process of being implemented, has been watered down, and is unlikely to be finalized this year. In the meantime, the new Glass-Steagall Act requires banks to get away from risky securities activities.”
A final Volcker rule has been delayed amid debates over how to effectively define those exceptions, and an overall reticence by banks to take on new regulations that could affect their liquidity. Regulators and Treasury Department officials have promised that a final rule will emerge by the summer of 2014.
BANK LIMITATIONS
The following are among the limitations imposed on banks by the “21st Century Glass-Steagall Act.”
The business of dealing in securities and stock by the association shall be limited to purchasing and selling such securities and stock without recourse, solely upon the order, and for the account of, customers, and in no case for its own account, and the association shall not underwrite any issue of securities or stock. The association may purchase for its own account investment securities under such limitations and restrictions as the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Board of Governors of the Federal Reserve System may jointly prescribe, by regulation.
In no event shall the total amount of the investment securities of any one obligor or maker, held by the association for its own account, exceed at any time 10 percent of its capital stock actually paid in and unimpaired and 10 percent of its unimpaired surplus fund, except that such limitation shall not require any association to dispose of any securities lawfully held by it on August 23, 1935.
A national banking association shall not invest in a structured or synthetic product, a financial instrument in which a return is calculated based on the value of, or by reference to the performance of, a security, commodity, swap, other asset, or an entity, or any index or basket composed of securities, commodities, swaps, other assets, or entities, other than customarily determined interest rates, or otherwise engage in the business of receiving deposits or extending credit for transactions involving structured or synthetic products.''
Source: U.S. Senate.
The new legislation could serve as a suitable backstop for the Volcker Rule, possibly as a replacement if it becomes too watered down after four years of tinkering.
“Dodd-Frank was a step forward, but it certainly didn't address the big issue of restoring Glass-Steagall and outlawing naked credit default swaps in which neither party has an insurable interest,” says Byron Dorgan, the former Democratic Senator from North Dakota who led the failed fight against repeal in 1999. “The big issues that caused this country such agony and led to a financial industry that went hog wild still remain to be solved.”
Still, the legislation may have little chance of going anywhere with a deadlocked Congress.
“It was a giant blunder that has cost this country dearly,” says Dorgan of the Glass-Steagall repeal.“But I do think there's a steep climb to get this new legislation passed. Wall Street has an unbelievable amount of influence with Congress. They demonstrated that when they got it repealed and I assume they will demonstrate it with their opposition to restoring it. Congratulations to the four of them for introducing this, but it is going to be an uphill battle.”
Others say it simply wouldn't work. “Glass-Steagall is like using 1930s medicine on a 21st century disease,” says Alex Tabarrok, an associate economics professor at George Mason University and a research fellow at the Mercatus Center, a conservative think tank.
He says this version of Glass-Steagall does not address the problems of the financial crisis which centered not on banks that accept ordinary deposits, but on the shadow banking system of non-bank financial intermediaries that lent money based on a slew of financial products like special investment vehicles, asset-backed securities, and repurchase agreements. “The demand for Glass-Steagall seems to be coming from a populist desire to return to the past when things seemed so much simpler,” he says. “Unfortunately, complexity is here to stay and populism doesn't make good policy.”
The proposed legislation doesn't get at the root problems that plague the banking industry, says James Kaplan, a member of the law firm Quarles & Brady's Corporate Services Group. "The answer is to demand better risk management,” he says. “The banks need to have extremely robust risk management programs. They need to vigorously vet the financial products and services that they are selling and have an active, oversight-driven board of directors that really understands what their business is and how they are doing it.”
Then there are those who say even if it was a good idea, it would be too difficult to put in place. “Substantively, it's going to be very difficult to implement,” says Hester Peirce, senior research fellow at the Mercatus Center.
Pierce says deposit insurance enabling banks to take on risk on the taxpayer dollar is a “legitimate concern.” “But I don't think the Volcker rule, or this, which is really Volcker on steroids, is going to be the answer,” she says.
Instead, Peirce thinks the legislation would push even more activity into the “shadow banking” system. “If we can have activities that occur outside of the safety net, which is effectively what the shadow banking system is, then that's not a bad thing,” she says.
The problem is that banks, in the past present and future, have been pulled in different directions regarding how to approach these non-traditional investment activities, Peirce says. During the financial crisis, for example, “Goldman Sachs got the order from on high that they had to convert to become a bank holding company,” she notes. “These kinds of artificial separations in the end don't end up doing much good.”
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