A Glass-Steagall History Lesson

So there’s good news for financial reform. Before we talk about it, we need to get in the time machine and travel back to the 20th century for a quick refresher.

History Lesson

So it’s 1933 and the banking sector, hammered by bank runs and suspicions of conflict of interest, has collapsed. You are a New Dealer, and you aren’t sure what to do. There are those calling for the government to simply nationalize the system, driving out private banks and replacing them with a government bank. Then there are those who are calling for an “associational economy” (or what we’d now call “corporatism”), where the government would promote and regulate concentrated cartels of industry to reduce so-called destructive competition. By relaxing laws around banking, you could end up with a very concentrated financial sector. and it’s better to just bail out a few firms, right? It may also just happen to be better for the planned economy…

Instead of these you come up with the brilliant solution to create a market out of thin air to solve these problems. Through the Glass-Steagall Banking Act of 1933 (which FDR had to be dragged kicking and screaming into signing), you do two things: you split commercial banking, the checking and savings accounts, from investment banking, and you create what is now known as FDIC, which insures individual bank accounts in commercial banks to prevent devastating bank runs, removing the problem from the rest of the 20th century. Meanwhile you also anesthetize the assets side of the commercial banks through regulation, to make sure this social protection from bank runs isn’t being manipulated.

As we once discussed with Perry Merhling, bank runs are fundamental problems to this system, so we need a “lender of last resort” as a safety net to commercial banks. Splitting business lines also removes the conflicts of interests and creates two competitive markets. This approach kept our large dynamic banking system intact while also bringing stability without forcing it to go towards a concentrated government sponsored private oligarchy or a government run bureaucracy.

And as David Kennedy has pointed out, this is a pretty great regulatory regime. There’s no large costs on taxpayers or on banks for Glass-Steagall. There’s no regulator discretion: there’s no “hey regulator, I am a major donor to political campaigns and I can help you with a cushy job post-government service” that can alchemy an investment bank into a commercial bank if the regulator had a lot of discretion. And in the opposite direction, market participants are clear on what the ground rules are going to be when they start to play the game. That’s a satisficing solution, one with clear rules for regulators and participants to follow.

Click here to learn about some breaking news in regulatory reform.

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