Glass-Steagall Redux

Last Thursday president Obama launched what could be the first of many attacks on the country’s financial system. The target last week was the practice known as proprietary trading. A proprietary trade is when a bank uses its own money to buy or sell equities, derivatives, or anything else they can find laying around that looks more profitable than loaning people money. The president wants banks to stop this because he and others believe that this activity is too risky for banks and helped lead to the financial implosion of 2008/2009. Many of the fungi interviewed in the financial press described the president’s move as ‘curious’ or ‘a step backward’. Backward, that is, towards the repealed law known as Glass-Steagall that separated commercial and investment banking. If the president’s proposal brings us ‘backwards’ to Glass-Steagall than it’s the most (only?) sensible move to date the administration has made in the area of finance and economics.

Here’s why: Back in May I tripped all over myself trying to explain how and why the financial markets started to behave like Artie Lange. One of the reasons I cited was the repeal of the Glass-Steagall Act. Having a bank play the equivalent of the house while its customers play poker is not conducive to good moral or economic outcomes. So by not allowing a commercial bank to act like, or own, a hedge fund may seem restrictive, it’s much needed.

The president’s proposal lacked details but that may have been a calculated move to make Congress fight it out while being soaked in cash from lobbyists. The lack of clarity made markets nervous and helped send the Dow down over 5% by the end of Friday. It seems bankers and institutional investors sell stuff when they think they’re about to get shafted, making sure to sell their stuff before yours (the house bets last but holds the cards). This lack of clarity coupled with the notion of reversing direction on the so called ‘modernization’ of securities laws in the late nineties fueled skepticism in the press.

Peter Wallison, writing in the Wall Street Journal, put up a clever argument as to why the ban on proprietary trading is not such a good idea:

“Because banks are government-backed, and privileged in many ways, their activities are limited by law and regulation. They are restricted in how they can use their insured deposits. The Glass-Steagall Act, despite what we constantly hear in the media and from people who should know better, still applies to banks; it forbids them from engaging in underwriting or dealing in securities. This should prohibit them from engaging in proprietary trading to the extent that this is dealing in securities. Bank holding companies, however, because they are not banks and not government-backed, can engage in any financial activity, including securities dealing. Why would we prohibit them from doing so when they are using their own funds? “

I count myself as one of the people Mr. Wallison believes should know better but gosh darn it here I goes anyway. If it turns out that Congress passes a law telling bank holding companies they can’t play online Texas hold ‘em with their own money, good! Yes, they are not using directly backed government funds but neither were AIG, Citigroup, or GM for that matter. But they all got infusions of government (taxpayer) funds because without their continuing operation, the economy would supposedly fall deeper into the abyss. By default (punny!) these large financial institutions are backed by the government just like a sixteen year old is backed by her parents when the gas money accidentally goes towards a new pair of Uggs. The fact there are financial institutions so large that their demise would sink a $14 trillion economy was also addressed by the Obama administration on Thursday but it’s not as exciting as the rise from the dead of Glass-Steagall (I know, I have goose bumps too!) so I won’t go there.

I like the president’s proposal in two ways. First, Glass-Steagall never should have been repealed. Second, the specificity of the proposal hopefully signals an end to this administration’s jones for huge, un-passable chunks of reforms.

Later