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Five Myths about Glass-Steagall

Thursday, August 16, 2012

There is a remarkable degree of ignorance about the alleged role of Glass-Steagall in the financial crisis. It’s time to set the record straight.

When Sandy Weill, the former chairman of Citigroup, told an interviewer that he thought it had been a mistake to repeal Glass-Steagall, it unleashed a gale of commentary that reflected a remarkable degree of ignorance about the alleged role of Glass-Steagall in the financial crisis. The five myths discussed below do not cover all the misconceptions that seem to be held by those who want to restore Glass-Steagall, but they cover some of the most widely discussed.

Myth 1: Glass-Steagall was repealed in 1999 by the Gramm-Leach-Bliley Act.

No. Glass-Steagall was never repealed. It is still applicable to insured banks and forbids them from underwriting or dealing in securities. What was repealed in 1999 were the sections of Glass-Steagall that prohibited insured banks from being affiliated with firms—commonly called investment banks—that engaged in underwriting and dealing in securities.

Myth 2: The repeal of Glass-Steagall allowed banks to use taxpayer-insured funds for risky trading.

No. The portions of Glass-Steagall that remained in effect after 1999 prohibited insured banks from underwriting or dealing in securities. However, before and after 1999, banks were permitted to trade (that is, buy and sell) bonds and other fixed-income securities for their own account. This is logical, because these instruments are simply a loan in a securitized form, and loans are the stock-in-trade of banks. Just as Exxon Mobil is allowed to trade oil, banks must be allowed to trade the assets that are an essential part of their business. This inevitably involved banks using insured funds for trading, which was permitted both before and after Glass-Steagall was amended in 1999. Calling this trading “risky” puts a thumb on the scale, but doesn’t change the fact that banks have always been allowed to trade securities they can invest in.

Myth 3: In the financial crisis, banks got into trouble by trading “risky” mortgage-backed securities (MBS).

The fact that insured banks suffered losses buying and holding AAA-rated MBS may say something about their investment acumen, but it says nothing about their trading or their risk-taking.

No. Insured banks got into trouble in the financial crisis by buying and holding MBS backed by subprime and other low-quality mortgages, not from trading these instruments. When these loans declined in value in 2007, they caused significant losses to the banks that had invested in them. This is the same thing as saying that banks got into trouble by making bad loans, but it has nothing to do with Glass-Steagall or its supposed repeal. In addition, these MBS were not seen as “risky” when acquired. The MBS that banks bought and held were rated AAA, the lowest risk MBS available. In buying and holding these instruments, banks received the lowest returns. If they had really wanted to make risky “bets,” they would have bought MBS rated below AAA, where the risks were greater and the returns correspondingly higher. The fact that insured banks suffered losses buying and holding AAA-rated MBS may say something about their investment acumen, but it says nothing about their trading or their risk-taking.

Myth 4: The repeal of Glass-Steagall allowed bank holding companies and bank-affiliated investment banks to use insured funds for risky trading.

Very unlikely. The 1999 change in Glass-Steagall allowed insured banks to be affiliated with investment banks, which could indeed take substantial risks in underwriting, dealing, and trading securities of all types. Investment banks—even those affiliated with insured banks—have no access to insured deposits. Moreover, banking regulations make it extremely difficult for insured banks to lend funds to, guarantee, or otherwise assume or support the risk-taking of their affiliates. Under provisions of the Federal Reserve Act, bank loans to affiliates have to be made at arm's length (that is, on the same terms as the bank would make to an unaffiliated party), must be collateralized by U.S. government securities, and must be limited in the aggregate to 20 percent of the bank’s capital. Even if the loans are made—which is seldom, if at all—they are risk-free because of their collateralization. It would make much more sense for affiliates to raise their funds in the capital markets, which is what they ordinarily do.

Myth 5: By allowing insured banks to affiliate with risk-taking investment banks, the 1999 change in Glass-Steagall caused losses to the banks that contributed to the financial crisis.

No. As noted above, insured banks suffered losses in the financial crisis by making bad loans—that is, buying and holding MBS based on subprime and other low-quality mortgages. Although investment banks could take more risks than insured banks and had much higher leverage, the investment banks that got into trouble in the crisis—Lehman Brothers, Bear Stearns, and Merrill Lynch—were not affiliated with any of the insured banks that had major losses, and thus could not have caused these losses. In addition, these investment banks got into trouble not by taking greater risks than insured banks but by buying and holding the same AAA-rated MBS based on subprime and other low-quality mortgages. Finally, there is no evidence that the small investment banks with which the insured banks were affiliated contributed in any significant way to the losses of the insured banks. In other words, if Glass-Steagall had never been amended in 1999, the financial crisis of 2008 would have happened exactly as it did. Those who spend their time blaming Glass-Steagall’s repeal for the financial crisis need to think again.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.

FURTHER READING: Wallison also writes “Dodd-Frank: The Economic Case for Repeal,” “Where No Mortgage News Is Fit to Print,” “A Guaranteed Disaster,” and “Is the Financial System Stable Without Regulation?” Edward Pinto discusses “Cleaning House: The Financial Crisis and the GSEs” and “How Fannie, Freddie, and Politicians Caused the Crisis.

Image by Darren Wamboldt / Bergman Group

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