Break Up the Big Banks?

Paul Volcker has suggested, as has Mervyn King, the Governor of the Bank of England (the U.K.'s version of the Federal Reserve), along the lines of the Public Utilities Holding Company Act or the Glass-Steagall Act, both passed in the 1930s and since repealed, that commercial banking (including lending by thrifts, and probably by money-market mutual funds as well) be separated from proprietary trading and other high-risk financial activities.

The reasons are several. One of course is the contagion of the kind that brought down Lehman Brothers; unless risky and safe activities are conducted in strictly separate subsidiaries--which is difficult to do without sacrificing whatever benefits flow from having both types of activity in the same enterprise--the assets involved in the safe activities will be available to the creditors of the risky activities. Not that banking can ever be completely safe, given that its essence is borrowing short and lending long, but it can be made much safer than it is.

Another reason for separating out commercial banking besides the contagion effect is the awkwardness of trying to merge disparate business cultures in a single firm. The combination is likely to be unstable if the different cultures have different risk profiles. A safe, conservative banking operation will attract a different type of executive from a speculative trading operation. The banker will be more cautious and, because of the positive correlation between risk and return, will be differently--and less munificently--rewarded. The greater profitability and more generous remuneration of the traders will nudge the bankers (or induce top management to pressure them) to increase the profitability of their own operations, which will require their taking greater risks. Thus the separation of commercial banking from other financial activities would automatically solve the problem for which limiting the amount or structure of compensation of financial executives is proposed as the solution. A career in a "safe" bank would not draw persons with a taste for risk.

There would be additional, and even greater, benefits to making commercial banking safe by forcing banks to divest their risky, nontraditional banking activities and thus creating a dike against inundation from a collapse of other parts of the financial system. Although nowadays commercial banks supply less than a quarter of the total amount of credit in the United States, they play a unique role. They provide essential financing for small- and medium-sized businesses (what is called "external finance")--businesses too small to meet their own financing needs out of retained earnings or by issuing bonds or commercial paper, or to be attractive to a lender that does not have an established relationship with the borrower which would enable the lender to evaluate the borrower's creditworthiness. If a bank fails, though other lenders remain, borrowers from the bank may find it difficult to establish the kind of personal relationship with a new lender that would reassure the lender that the borrower was creditworthy.

Relationship banking declined during the current depression not only because of fear of default and a fall off in demand for loans, but also because the relationships that sustain relationship banking had withered in banks that had embraced the new model of originating and purchasing securitized debt. Creating securitized debt for a fee, or buying securitized debt, involves no relationship with the debtor. (This is an argument for limiting securitization by commercial banks.)

Banks also provide standby lines of credit that provide emergency funding when other sources of credit fail, as happened when the commercial-paper market froze in the wake of the collapse of Lehman Brothers and the near insolvency of other broker-dealers that had been intermediaries in that market. (Issuers of commercial paper normally have standby lines of credit from commercial banks, should the usual purchasers of their paper defect, as Lehman did.) Banks thus back up the riskier lenders.

And they are the normal conduit by which the Federal Reserve pumps cash into the financial system in order to increase the amount of lending, whether by lending money to banks directly or more commonly by buying short-term Treasury securities from them (or lending money to the banks, taking the securities as collateral, by means of repossession agreements), thus increasing their lendable cash. (Put differently, the commercial banks are the instruments by which the Fed regulates the money supply--in normal times, at any rate.) It is easier for the Fed to recapitalize a bank than to recapitalize other types of financial institution. And the Federal Deposit Insurance Corporation has authority and expertise that enables it to close a failing bank and transfer its assets to another bank with minimal disruption of its business.

Were commercial banks forbidden to affiliate with other entities, the danger of a financial crisis that would engulf the commercial banking sector would be minimized. Even when a nationwide housing bubble bursts and mortgages are a significant component of the asset portfolios of most banks, with the result that the capital of most banks is impaired, the Fed can prevent their collapse by pumping cash into them. In fact the primary victims of the banking collapse of September 2008 were not commercial banks but other financial intermediaries.

Part of the reason is federal deposit insurance, which protected most commercial banks from the runs that brought down Bear Stearns and Lehman Brothers and would have brought down Merrill Lynch, Morgan Stanley, and Goldman Sachs within days of Lehman's collapse had the government not intervened by arranging the sale of Merrill to the Bank of America and the conversion of the other two firms to bank holding companies, which placed them under the Federal Reserve's regulatory authority and thus gave them access to the "discount window"--which just means, made it easy for them to borrow money from the Fed. This option reassured investors and stopped the run that was threatening to deprive the firms of the short-term capital that they needed in order to continue in business.

With the commercial-bank industry sealed off from other financial intermediation, the Federal Reserve's independence would be protected. It would, as it did until the financial crisis of 2008, be operating solely within the orbit of commercial banking--quietly regulating commercial banks and moving interest rates up and down by esoteric means (how many people know what "open market operations" are?). The Fed would not be making life and death decisions regarding the huge Wall Street firms, as when it refused to provide financial CPR to Lehman Brothers--firms that whether called banks or bank holding companies or something else are engaged primarily in speculation rather than in banking in the sense described above. There is nothing evil about speculation, as ignorant people think, but it can create macroeconomic risk, and that is a powerful reason for separating it from commercial banking.

That would leave the question of what to do with those shadow banks. Stripped of their connection to commercial banking, they would again fall under the regulatory aegis of the SEC, which is notable for a lack of expertise and even interest in macroeconomic risk. The simple answer would be to create a new division in the SEC that would be responsible for macroeconomic risk regulation of firms regulated by the commission. There is time to form such a division and bring it up to speed, since the major shadow banks, as a result of the convulsions of 2008, are no longer regulated by the SEC; apart from Lehman, which was liquidated, they were either bought by commercial banks or converted to bank holding companies, and in either case are now regulated by the Fed and other bank regulatory agencies.

Money-market funds are a type of mutual fund, regulated by the SEC, that provide checkable accounts that pay higher interest than demand-deposit accounts in commercial banks. They earn the interest out of which they pay interest to their account holders by investing in commercial paper and other short-term securities. After a run on money-market funds began following the collapse of Lehman Brothers, in whose commercial paper some of the funds were heavily invested, the federal government provided temporary insurance of the accounts. Money-market funds, like thrifts (mortgage banks), are so similar to commercial banks that all three types of financial institution probably should be regulated on the same principles, emphasizing safety and therefore separation from other types of financial institution. Separation would eliminate the need for a "systemic-risk regulator." Commercial banks would not be a source of such risk; the sources would be under the regulatory aegis of the SEC.

I said that the separation of commercial banking from other financial intermediation should be considered--not that it should be ordered forthwith. It would be a formidable undertaking, fiercely opposed; and the argument that separation would sacrifice significant economies of scale and scope, while unsubstantiated and rather implausible (think of Citigroup and Bank of America, whose travails seem to have been amplified rather than diminished by the scope of these banks' activities), would have to be carefully appraised.

Merely reenacting the Glass-Steagall Act (and repealing the statute that repealed it)--the New Deal statute that separated commercial from investment banking--would not avoid the complexities involved in divestiture. As explained by Robert Pozen ("Stop Pining for Glass-Steagall," Forbes, Oct. 5, 2009, (visited Oct. 13, 2009)), "Even under Glass-Steagall commercial banks could invest in bonds, manage mutual funds, execute securities trades on the order of their customers and underwrite government-related securities. The main thing they couldn't do was underwrite corporate stocks and bonds...The main impact of repealing Glass-Steagall was to allow banking organizations to become more active in underwriting." So a greater rollback of financial deregulation than merely re-enacting the Glass-Steagall Act would be necessary for a clean separation of commercial banking from other financial intermediation. (Greater, but in one respect lesser, as there is no good reason to forbid commercial banks from underwriting securities issues, a central prohibition in Glass-Steagall.)

Such a rollback is conceivable, if barely, but there is a further hitch, as Pozen goes on to explain in the piece that I quoted from: "The repeal of Glass-Steagall facilitated the rescue of four large investment banks and thereby helped reduce the severity of the financial crisis. When Bear Stearns and Merrill Lynch got into serious trouble, they were promptly acquired with federal assistance by JPMorgan Chase and Bank of America, respectively. These rescues happened only because banks could own full-service broker-dealers. When Goldman Sachs and Morgan Stanley were challenged to find adequate short-term funding, they were allowed to quickly convert from broker-dealers into bank holding companies. Banks have a significant advantage over broker-dealers in obtaining short-term financing in illiquid markets.

A bank can rely on insured deposits and Fed loans as well as short-term financing in the form of commercial paper. Commercial paper buyers are a fickle bunch. Bank depositors are more stable retail customers." All true; but the Federal Reserve can lend to a firm that is not a commercial bank, even if the borrower has lousy collateral (Bernanke's argument that it cannot do this is not a persuasive interpretation of the Federal Reserve Act); it can also guarantee the borrower's debts. It is not obvious that these are inferior solutions in an economic emergency to forcing a merger with a bank.

(Photo: Getty Images/Timothy A. Clary)