Economic Populist: Glass-Steagall Is Not Enough Anymore

Burning the Midnight Oil for Economic Populism

From Treasury and Risk: "U.S. Banks Spawn 10,000 Units":

The biggest U.S. banks created more than 10,000 subsidiaries in the past 22 years as they expanded, using legal structures to pay lower taxes and escape tighter regulation, according to a Federal Reserve study.
Critics including Thomas Hoenig, a Federal Deposit Insurance Corp. board member, say the biggest firms are too complicated to manage. The 2010 Dodd-Frank Act asked the FDIC and Fed to make sure the largest banks, if they get into trouble, can be wound down without collapsing the rest of the financial system. U.S. Senator Sherrod Brown has proposed legislation to force their breakup.
The 1999 repeal of the Depression-era Glass-Steagall Act was the main catalyst for the biggest banks getting bigger, the Fed study concluded. The assets of the largest lenders have since tripled to $15 trillion. Hoenig has called for reinstating Glass-Steagall, which separated investment and commercial banking, while Brown’s proposal would limit asset size.

Why should Commercial and Investment Banks Be Separated?

Lets return to the Go-Go days of the 1920's. From Washington's Blog: Fraud Caused the 1930's Depression and the Current Financial Crisis (30 Oct 2010):

Professor William K. Black writes:
The original Pecora investigation documented the causes of the economic collapse that led to the Great Depression. It … established that conflicts of interest and fraud were common among elite finance and government officials.

The Pecora investigations provided the factual basis that produced a consensus that the financial system and political allies were corrupt.

Moreover, the Glass Steagall Act was passed because of the fraudulent use of normal bank deposits for speculative invesments. As the Congressional Research Service notes:

In the Great Depression after 1929, Congress examined the mixing of the “commercial” and “investment” banking industries that occurred in the 1920s. Hearings revealed conflicts of interest and fraud in some banking institutions’ securities activities. A formidable barrier to the mixing of these activities was then set up by the Glass Steagall Act.

And this was not "merely" criminal misbehavior. This is a systemic problem. As explained in one chapter of the standard macroeconomics textbook, with its implications then hurriedly obscured and obfuscated in the following chapter, commercial banks have the power to create money.

The reason for this is straightforward. Banks lend money by creating an loan account ~ a promise to pay, aka "a liability" ~ which is paid out when the loan check clears. The loan contract itself is a promise from someone to pay the bank for the use of the money and to also give the money back, over time ~ aka "an asset". And it is the asset ~ the loan contract ~ that stands behind the new loan account.

Since most payments start in the banking system and end in the banking system, if using their reserves account at their Federal Reserve bank to clear the loan check leaves the bank short of reserves, it can borrow the reserves overnight from a bank that had extra, until they get their reserve balances back to where they need to be.

People who labor under the fiction of money as some kind of real thing react to this with outrage, but this is how things should be. Money, after all, is not a resource. Resources are people with the skill and experience to get things done, the tools that they use and the places set up to accommodate them, and the natural resources required as material and energy inputs into the system. The money is just a form of permission slip that is used to gain control over resources.

In a well functioning system, its like Jimmy Stewart says in "Its a Wonderful Life":

Now, what is investment banking? When corporations offer financial obligations ~ purchased by others to hold as financial asset ~ they rely on the assistance of financial institutions to underwrite the offering. Underneath the con-games and frauds and Ponzi Schemes that they get involved in when things get out of hand, that is their core business. They ought to hold some of the offerings, so that if the assets are duds, they suffer from the transaction as well.

That's the "sell" side, and most investment banks combined that with the management of portfolios of assets for customers ~ pension funds, mutual funds, hedge funds ~ as the "buy" side of the investment bank.

Now, combine the core businesses of a commercial bank, clearing payments, and then using their position in clearing payments to create money to lend, and combine it with the core business of an investment bank, making money on transaction fees in the process of underwriting the issue of new corporate liabilities.

Hey! (You think to yourself) ... if you are in the business of making money on what are basically sales commissions, wouldn't it be handy to have a tame bank that you can use to create money so that your customers can buy your products? Why, sure, sure it is.

Of course, commercial banks are at the center of the monetary system of a modern industrial economy, so a massive collapse of commercial banks can bring a modern industrial economy to its knees. Therefore, there are pesky rules and regulations that attempt to see to it that banks engage in prudent lending. So the toxic mix of commercial and investment banking has a strong incentive to (1) find ways to engage in imprudent lending that are not yet regulated and (2) break those rules that are in fact in place.

And that's why we need Glass-Steagall: the ability to create money cannot be separated from modern commercial banking, and the ability to create money should never be housed in the same organization as the process of underwriting new corporate liabilities.

... But Glass-Steagall Is Not Enough

So, re-instate Glass-Steagall and we're done, right?

There's an additional problem that we didn't have when Glass-Steagall was first implemented in the 1930's. The problem, indeed, is part and parcel of the process of whittling away the limitations imposed by Glass-Steagall that was undertaken prior to the legislation being repealed, under the watchful eye of Clinton's Treasury Secretary Rubin, previously from Goldman Sachs.

Consider the history of the major investment banks of the United States. Drexel Morgan and Co. was founded in 1871 as a partnership of J.P. Morgan and Anthony Drexel. In 1895 it became J.P. Morgan & Co. After Glass-Steagall, J.P. Morgan elected to operate as a commercial bank, and spun off its investment banking operations under the partnership of Harold S. Morgan and Harold Stanley, who founded Morgan & Stanley.

Morgan and Stanley grew through the fifties and sixties, but J. P. Morgan & Co. was only a mid-sized commercial bank until it merged with New York Guarantee Trust, a bank five times its size, in 1959. In 1969, it established a bank holding company, J. P. Morgan & Co., while continuing to operate as Morgan Guarantee until 1988. In 1989, the Federal Reserve allowed J. P. Morgan to be the first commercial bank to underwrite a corporate debt offering.

This was before Glass-Steagall was repealed, so what was going on here? Well, J.P. Morgan & Co. was not a commercial bank, it was a bank holding company that owned a commercial bank. It wasn't the commercial banking "arm" that engaged in the activity. And there were supposedly "firewalls" between the commercial banking subsidiary and the investment banking operations of the bank holding company.

After the 2000 merger with Chase Manhattan bank that formed J. P. Morgan and Chase.

And Morgan Stanley? From the Wikipedia machine, a critical change happened in the eighties:

In 1986, Morgan Stanley Group, Inc., was publicly listed on the New York Stock Exchange.

Think about how incestuous this is. An organization whose role is to manage the creation, and funding of commercial corporations traded on public exchanges is itself a commercial corporation traded on a public exchange.

Morgan Stanley was one of the two investment banks left standing after the Panic of 2008, alongside Goldman Sachs, and like Goldman Sachs, decided to reorganize as a bank holding company, under the regulation of (and with access to loans of reserves from and sales of assets to) the Federal Reserve system.

That's global Investment Bank number 1 (JP Morgan and Chase), and 4 (Morgan Stanley) on the list of US Investment Banks. Number 2? Merrill Lynch went public in 1971, and in the great merger frenzy of 2007/2008, it was acquired by Bank of America. Number 3? Goldman Sachs went public in 1999 (the year that Glass-Steagall was repealed), and became an bank holding corporation during the Panic of 2008.

Investment banking used to be businesses organized as partnerships. And as partnerships, the financial capital of the firm was the financial capital of the partners. When Penn Central went bankrupt, $80m in unsecured corporate paper became worthless and it nearly dragged Goldman Sachs under, after which holders of commercial paper started demanding credit ratings for the issuing companies.

But in a long process starting in the 1960's and culminating in Goldman Sachs going public in 1999, investment banking became organized as public corporations.

This incorporation is also part of the process that fueled that massive wave of control fraud that underlay the Panic of 2008. Incorporation shifts the focus from the career of the partners to the current quarter of financial returns. And, of course, when you put the process of underwriting publicly trade corporate assets in the hands of a publicly traded corporation, you create a tremendous motivation for that corporate investment bank to game the system to juice its returns, boosting the value of its stock, and delivering instant phony profits that is diverted as real income to its senior managment in the form of "profits" on stock options included as part of their pay packet.

Dis-Incorporate Investment Banks!

Ok, so the slogan, "Dis-Incorporate Investment Banks" is not likely to rally people to the barricades. It is, indeed, a bit boring.

But that's as it should be. Banking ~ both commercial banking and investment banking ~ should be boring. Its when commercial and investment banking get to be too interesting that the rest of us are certain to suffer the interesting impacts of financial crises, followed by a frontal assault on our incomes as the banks seek to tap whatever flows of incomes are out there to restore their balance sheets.

So, I fully favor Sherrod Brown's proposal to limit the size of banking institutions. And the proposal to reinstate Glass-Steagall. However, those alone are not enough. We have to ban all commercial corporations from engaging in investment banking activities.

Message from Marley: Stir It Up

There's ongoing disgust with the behavior of banksters in our economy, but with the indictment of the perpetrators of fraud "of the table" from either the Hedge Fund Democrat or Private Equity Republican in the Presidential race ~ it is not something that the highly paid stenographers that pose as journalists in our major newspapers is going to cover.

Its something that we have got to keep stirring up, if we want to see these frauds brought to justice and the system reformed to bring them back under control.




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Great work. This should be added to Glass Steagall...

priceman's picture

and Sherrod Brown should add it to the Safe Banking Act. The points you make and the history of investment banks going public and what not, commercialism banks, partnerships is something we need to talk about more. I would add that the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 that repealed the interstate restrictions on acquisitions of the Bank Holding Company Act.

There, a nice comment, but you must know we populist are an angry bunch these days and this election is not going to do much for it because none of this is on the agenda at all in the executive regardless of the election. Sherrod Brown should listen to it though but assuming he does he needs to be more vocal after the election when the White House works with Republicans and others to kill the Safe Banking Act.

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This election? You mean ...

BruceMcF's picture

... working toward the 2014 primaries?

Or you mean the general election campaign? Sherrod and Bernie and Elizabeth and ...
... well, after that I don't know. I'm afraid I haven't been following the pollie picking process as much as the votes here in Ohio to retain the right to vote and to fix the broken districting system.

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The general 2012 election...

priceman's picture

which sucks the air out of everything else in the room. For instance, Darcy Burner lost her primary to her millionaire hedge fund Democrat primary opponent. Not that you would know it, because no one is talking about it.

But seriously until election reform on a whole is a standard bearer issue, as it is in your state, focusing on elections will be a flawed however well meaning exercise. That is the thing to be focused on and it looks like you are in Ohio.

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thanks for a well put lesson in...

poligirl's picture

the historical aspects of our banking systems. i'm generally a dumbass when it comes to economics, so plainly put posts are greatly appreciated...

i have to agree, it's not only Glass Steagal that needs reinstatement, we need to break up the banks or break down the banks rather. but in the system we have right now, that is not likely to happen, what with how intertwined the pols are with the banksters that underwrite them....

sigh.... great post Bruce! :D

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That's why the SuperPACs are running ...

BruceMcF's picture

... ads against Sherrod $6:$1, he's considered to be the combination of most populist and most at risk. A limit on the size of banks would be a substantial step in the right direction.

And when you have a Senator pushing something, who knows when conditions are going to be right for it to go through? Predicting the make-up of the House and Senate six year ahead is a risky thing. So getting rid of him is a win for the banksters.

Replacing him with the State Treasurer who can't be bothered to attend meetings and hires his best buds to spot they are not qualified for ~ a back-up for that empty suit little Scottie Brown in case he does not survive ~ that would just be a bonus.

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Sherrod is one of the few...

poligirl's picture

in Congress who i think does his job the way it was intended... :D

sometimes it seems so hopeless and futile to even dream of decency coming from Congress at large...

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