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Many now advocate bringing back Glass-Steagall. But resurrecting the act that separated commercial banking from securities issuance between 1933 until its repeal in 1999 would not be the guarantee of banking safety many imagine it would. Paul Volcker, head of President Obama’s economic recovery advisory board, is the latest to argue for a two-tier financial system. On one side would be casino-like investment banks. On the other would be regulated and utility-like commercial banks enjoying government protections, such as deposit insurance.
This proposed solution oversimplifies the issues. The 1980s Savings & Loans crisis was caused by “safe” utility-like lenders. And in this crisis the first banks to go down were commercial banks, such as Northern Rock and Germany’s IKB. The next to collapse were pure investment banks, such as Bear Stearns, Lehman Brothers and Merrill Lynch – none of which had commercial lending operations. Fannie Mae and Freddie Mac went next – and they were as utility as you can get. It was only later that universal banks such as Citigroup, UBS and Royal Bank of Scotland came a cropper.
The problem, then, was not that these banks combined a securities operation with commercial lending. Rather, it was that they were massive and imprudent lenders, with too little capital. Furthermore, much of that lending was sliced and diced in the securities markets and then stashed in off-balance sheet vehicles that had lines of credit back to the banks, plus other guarantees. This is where the real problem lies: in the fuzzy relationship between banks and the opaque world of the shadow financial system where enterprises can create system-threatening levels of leverage, whatever they are called – a commercial bank, a prop desk, an investment bank, or Citigroup. A new Glass-Steagall would be no panacea.
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