Graduate assignment prepared for EC 642: Applied Macroeconomics.
Glass-Steagall was the brainchild of a Senatorial committee intent on finding the leading cause of the 1929 stock market crash. Separating traditional commercial banking activity from the speculative work of the securities industry, they believed, would be a significant factor in reducing the corruption which inevitably led to a stock market bubble. Broadly speaking, this committee was right – the separation of commercial banking from securitization has reduced the boundless opportunities for speculative bubbles. But over the next 70 years, the law became the victim of inevitable shifts in the political economy, and its tenets have since eroded. In 1999, a partial repeal of Glass Steagall took the industry down a controversial pathway, one that many experts believe set the stage for the 2008 financial crisis. The separation of commercial from investment banking waned as grey areas became more profuse, and the 1956 Bank Holding Company Act loosened restrictions further by allowing banking entities to own companies engaged in nonbanking activities. In any industry, conglomeration does not guarantee complete separation, and corporate accounting practices often vary. What followed was a series of policy changes at the OCC and the Fed, as well as through the courts, which led to commercial banks engaging in collateral lending such as that of automobiles, mortgages, and other financing vehicles.
The 2008 financial crisis made public the role of the financial industry in determining the overall health of the economy at large. Since then, a lot of attention has been paid to how the industry should be regulated, and it has been the topic of heated contention across the ideological spectrum. The balancing act of ensuring growth and maintaining stability has emboldened some to propose bringing back Glass-Steagall, that is, to reinforce the separation of investment and commercial banks. This idea gained some traction in the political sphere, pointedly in the Democratic presidential primary debates when Martin O’Malley made it one of his signature issue platforms in financial regulation. This idea became increasingly mainstream as the Democratic primaries ensued, and Senator Bernie Sanders made this his rallying cry for bringing power back to the people via “breaking up the big banks”. The political strategy behind this was clever, capitalizing on residual frustration of the Occupy Wall Street movement, and thus, giving it a face and a message. Since the election, the Glass-Steagall debate has ostensibly receded from public debate, making way for more pragmatic discourse that rarely grabs the attention of everyday political newsreaders, validating its more theoretical purpose. The Sanders campaign derived symbolic meaning from an nonviable policy proposal, using this to regenerate the disillusioned masses whose 2011 protests were met with public derision.
In 2010, the Federal Reserve Bank of St. Louis created an index to measure stress levels in the banking system, measuring 18 weekly data series combined into a summary variable that measures overall default risk of high risk instruments, low risk instruments, and liquidity risk. Their findings revealed a consistently higher stress level in 1994 – 2000, when Glass-Steagall was in force. This is compared to the lower stress levels following the 2009 enactment of Dodd-Frank, after which the stress levels have been markedly low.
One of the largest contributors to the recent crisis was the issue of many banks being undercapitalized. Extremely low capital ratios were the industry standard before the crisis, with the largest banks able to operate with very low levels of equity. Highly leveraged institutions were sent into a tailspin when the beginnings of the housing market crisis led to a liquidity crisis. What followed was a series of very real economic consequences, beginning with term auction facilities, continuing with the Fed’s desperate attempts at revival via the Total Asset Recovery Plan, and commencing with a $700B fiscal stimulus package, passed into law by the 111th Congress and signed by the newly elected President Obama. The issue of overcapitalization is one that is addressed in Dodd-Frank legislation, but not in the politically popular Glass-Steagall. Preventing another liquidity crisis, the legislation outlines, is contingent upon banks maintaining sufficient liquidity and capital ratios; Dodd-Frank requires a leverage ratio of 20:1 assets to equity. This priority is also pushed by the recent enactment of the Basel Committee’s Liquidity Coverage Ratio, a premise that has been under tight scrutiny among some members of the banking industry.
Although the financial services industry has evolved greatly in the past several years and its appetite for risk has lowered significantly, the NYU Stern School of Business has measured systemic risk in a different way. Through their calculations, the banking industry has not quite achieved its pre-recession lows in terms of systemic risk, by their definition, at least. Their methodology has incorporated the societal costs, or externalities, which would be imposed upon bank failure. Looking at each bank’s propensity for undercapitalization, or its Systemic Expected Shortfall, it considers each institution’s current capital ratio, comparing that against the amount of funds needed to liquidate in the event of a crisis. Their calculations find the top 10 institutions with the highest level of systemic risk posed to society to be: Prudential Financial, MetLife, Citigroup, Bank of America, Morgan Stanley, Lincoln National, Principal Financial Group, Goldman Sachs, Genworth Financial, and Hartford Financial Services Group. In other words, if these institutions were to fail, the negative externalities upon society would be significantly higher than those of any institution not mentioned.
Critics of the legislation point to a long-term trend of consolidation in the banking industry, citing Dodd-Frank as a primary reason why the number of industry players decreases almost daily. Multiple Congress members, policy analysts, and bankers have stated their frustration in watching the number of small community banks diminish, especially in the wake of the recession. Upon taking a closer look, however, the FDIC has found that the reasons for community bank closure have little or nothing to do with Dodd-Frank legislation, and the enactment of Glass-Steagall would have minimal effects on the creation of new market entrants. The most significant contributor to this phenomenon of consolidation is the number of mergers and acquisitions that have taken place in the banking industry. An overwhelming majority of these consolidations occurred under the oversight of Glass-Steagall, prior to its partial repeal through the Gramm-Leach-Bliley Act of 1999. Many experts who have taken a closer look at the issue have pointed to the Riegle-Neal Act of 1994, which expanded interstate banking and led to a wave of mergers, as well as Gramm-Leach-Bliley. These factors point to a simple conclusion that one might draw upon reviewing this: that economies of scale are far greater reasons for growth and consolidation than increased capital ratios and compliance fees.
Although the changing nature of the banking industry has presented several problems, it is difficult to tie these issues to the requirements under Dodd-Frank. It is even more difficult to present a data-driven case that would significantly reduce the risk of recession in the event that Glass-Steagall were reinstated. The trends identified have consistently pointed to a more natural economic phenomenon, that of economies of scale for larger banks, and a merger-driven environment that offers many benefits of vertical integration and/or conglomeration. The fact that these problems have persisted since long before the recession points to the fact that they are indicators of a long-term shifting trend in the industry, of an industry that is evolving for better and for worse.
 Carpenter, David H., Murphy, Edward V., Murphy, Maureen M. 19 January 2016. The Glass-Steagall Act: A Legal and Policy Analysis. Congressional Research Service.
 St. Louis Fed Financial Stress Index. 5 January 2017. Federal Reserve Bank of St. Louis.
 Kessler, Jim; Liner, Emily; and Oppenheimer, Lauren. 18 November 2014. Demystifying Dodd-Frank: 14 Ways It Reforms the Financial System. Third Way.
 Finkle, Victoria. 18 August 2015. Is Dodd-Frank Really Killing Community Banks? American Banker.