Restoring The Glass-Steagall Wall

The Glass-Steagall Act saved the world from Depression for nearly 80 years. It's celebrated elimination nevertheless created opaque markets, where all kinds of septic practices could flourish without restraint, as we have recently discovered, to our sorrow. Restoring Glass-Steagall would help clarify markets and thus leads to market trust and stability. Otherwise, it's caveat emptor: the law of the jungle for everyone!:

John McCain lost the 2008 presidential election because of the financial crisis—at least that's what his chief strategist, Steve Schmidt, suggested. "We were three points ahead on Sept. 15 when the stock market crashed. And then the election was over," Schmidt said in a postmortem earlier this year. McCain was tarred with the regulatory failures of the Bush years, and it didn't help that he had been a longtime acolyte of the Senate's dean of deregulation, Phil Gramm, who once derided Americans as "a nation of whiners." McCain also seemed to have few new ideas of his own about how to address the financial panic.

More than a year after the election, the Arizona Republican is looking to repair that reputation by joining up with Democratic firebrand Maria Cantwell to propose something that will be anathema to both Wall Street and the Obama administration. According to two congressional sources, the two maverick senators want to reinstate Glass-Steagall Act, the Depression-era law that forced the separation of regular commercial banking from Wall Street investment banking. The senators' proposal echoes a failed amendment introduced in the House last week by Rep. Maurice Hinchey of New York.

...Bankers and regulators, Volcker said earlier this month, "have not come anywhere close to responding with necessary vigor" to the crisis. He wants to ban federally guaranteed commercial banks from risky trading in derivatives and other arcane instruments that could precipitate another huge bailout some day. That too is a proposal no one who currently controls the levers of power in Washington is considering. But among those who now support Volcker is Arthur Levitt Jr., the former chairman of the Securities and Exchange Commission. "I tend to be in the Volcker camp in saying banks should either be investment banks or take deposits and make loans," Levitt told me in an interview this week.

Obama administration officials have dismissed the idea that the financial sector should or can be changed in more fundamental ways than they are now proposing. You can't turn back the clock, they say, and the new requirements they plan to impose on big banks to hold more capital in reserve, put up $150 billion for a rainy-day rescue fund, and disclose more of their risky trades should be enough to keep the financial sector from imploding again. Many of these requirements, among others, are contained in two giant bills making their way through Congress—one that passed the House last week and another that will be debated in the Senate in the new year. "I think going back to Glass-Steagall would be like going back to the Walkman," says one senior Treasury official.

But Obama and his economic team are also coming under increasing attack from their own liberal, reformist base for paying more attention to health care and other issues than to the causes of the biggest crisis since the Great Depression. Among the harshest critics has been Cantwell, who has pressed Treasury Secretary Tim Geithner to take a firmer stand in preventing loopholes in derivatives legislation. "I think they've [the Obama team] said the right things, but they've left it entirely up to a Congress which is seduced by lobbying pressures," says Levitt. "Health care has become such a compelling initiative that everything else has taken a back burner."

...Indeed, after last year's crash some experts concluded that the repeal of Glass-Steagall had little to do with it. After all, everybody—investment banks, nonbanks, insurance companies—had gotten into trouble: firms, in other words, that were not ostensibly changed by the repeal. Some even argued that the absence of Glass-Steagall made the cleanup easier: it allowed Bank of America to buy Merrill Lynch, for example.

But that critique missed a larger point that McCain, Cantwell, and other critics are now trying to address. The blinding complexity and interconnections created by modern capital markets—especially because of the way nearly half a trillion dollars in derivatives trades linked the firms to each other—demanded that there be strong firewalls and capital buffers between Wall Street institutions and their affiliates, and between banks and nonbanks and insurance companies. Otherwise there would be no islands of safety—no healthy institutions left to come and rescue the day, as commercial banks traditionally had done since the days of J. P. Morgan's famous bailout in 1907. The repeal of Glass-Steagall took things in precisely the opposite direction, eliminating most of the firewalls and inviting staid commercial banks into the buccaneering world of Wall Street trading. Representative Hinchey says it "was a recipe for disaster because these banks were empowered to make large bets with depositors' money, and money they didn't really have. When many of those bets, particularly in the housing sector, didn't pan out, the whole deck of cards came crumbling down and U.S. taxpayers had to come to the rescue."

Today the walls between firms still seem low indeed, and trading in derivatives that are "over the counter" (that is, out of public sight) continues at an astonishing pace, having risen back up to nearly $600 trillion worth. One big danger sign ahead is that the biggest banks have gotten even bigger in the aftermath of the catastrophe, and under the new rules requiring swap dealers to post capital for margin requirements, the big banks are likely to monopolize even more of this derivatives market and become that much richer and more powerful. That won't necessarily be a problem—unless the next crash proves once again that they cannot be allowed to fail, and the government must step in. Until McCain and Cantwell decided to speak out, very little that is currently under consideration by Congress or the executive branch would have changed that.