On Financial Reform

There are now efforts on the Hill to do something about the financial system. While some bemoan the fact this has not happened yet, my guess is the administration simply put health care reform first on the agenda for whatever reasons.

So -- what do we do about the financial system?

Let's start with two observations.

The first is the financial system stands at the middle of the economy. Often times the phrase "financial intermediary" is used to describe a bank or other financial player. These companies take individual finances like small savings accounts and pool them into larger amounts of money that then go to finance large projects. Hence, they act as intermediaries. In addition, the Federal Reserve effects the economy through these institutions. These actions by the Federal Reserve fundamentally impact the direction of the economy. Because of the unique roll these institutions play in the economy they must be looked at differently. At a minimum, these institutions must be functioning at a basic level in order for the US economy to work.

Secondly, there are different types of intermediaries that are largely classified by the type of risk they undertake. As an example, take an investment bank, which is:

A financial intermediary that performs a variety of services. This includes underwriting, acting as an intermediary between an issuer of securities and the investing public, facilitating mergers and other corporate reorganizations, and also acting as a broker for institutional clients.

... and compare that to a standard bank which "borrows short and lends long," meaning they take in deposits, pool them and make loans with the pooled money. Notice these institutions still perform financial intermediation, but perform the roles in far different manner.

Let's combine these points.

The second Glass-Steagall (which was repealed with the Gramm-Leech-Bliley Act in 1999) prevented different financial intermediaries from participating in certain other types of financial intermediation. For example, a commercial bank -- which lent money to corporations/larger borrowers -- couldn't own a brokerage company/investment bank. The reason is that these types of financial companies had very different risk profiles. While the commercial bank did take on risk it was usually far less than an investment bank's risk. Hence, by preventing certain types of companies with a certain risk profile from owning another company with another risk profile, the legislation essentially prevented risk from being centered in one or more institutions -- more commonly referred to as "too big to fail."

Here's an example. Sometime over the last few years Bank of America -- a bank -- purchased Merrill Lynch -- an investment bank. This could not have happened under the old Glass-Steagall Act but can happen now. Also note the different financial services each offers. Bank of America takes in deposits and makes loans whereas Merrill Lynch is a brokerage company that buys and sells securities along with other, riskier investment banking operations.

The primary benefit of Glass-Steagall is separation/segregation of risk. The act essentially prevents risk from being concentrated in a small group of institutions at the center of the economy. However, there is a drawback -- and it is a large drawback. It prevents "one stop shopping" for financial services. For example, large company X needs a variety of financial services such as general corporate banking and investment banking. By preventing consolidation, the Glass-Steagall Act does not allow larger companies to consolidate operations, thereby lowering cost through economies of scale.

Let's return to the Bank of America/Merrill Lynch example. By combining services, Bank of America can now service a larger group of clients (individuals to companies) and perform a far wider swath of services (banking and investment banking). While this does combine risk it also allows the company to increase its customer base and lower cost through economies of scale.

Many have blamed the repeal of Glass-Steagall as a primary driver of the financial meltdown that started in 2007; hence, putting it back in place should be part of financial reform. The repeal of Glass-Steagall was clearly a factor. But suppose that instead of occurring in a lax (or non-existent) regulatory environment, regulators had been far tougher on larger institutions. For example, suppose simple mortgage under-writing standards were more stringent (like actually requiring a meaningful down payment for a house). Would that have prevented the melt-down from occurring? There is no answer for that. However, the point is there is more than one way to look at financial reform.

 

Comments

[FreeNemo]

If convenience is so valuable, then it can be brokered through a third party. The takeaway here is that weath creates wealth, and there is a positive feedback loop for a single player or two to runaway with the whole game. Any engineer will tell you that a positive feedback loop is inherently unstable, so it must be balanced with some sort of regulation to keep it in check. Our economy is no different.

We need an automatic tax cap on market-share revenues of ALL large industries -- not just financial, but retail, auto, and the like. Would the country really be hurt if we hobbled WalMart a bit? What if we never let GM get so fat and lazy? Too Big To Fail is Too Big To Have....

[John Garner]

Oh if only honest people ran the economy

[helen]

Let's see, according to the author, CONVENIENCE is more important than SECURITY.

I think that sums up Wall Street and DC in one fell swoop.

[ADunafraid]

That is one way of looking at it.

Another way is that the Glass Steagal Act created a barrier to monopolies in our financial industry. This was accomplished by preventing the two wealthiest business sectors in the world from performing the same actions and ultimately buying each other up to become oligopolies.

"allow larger companies to consolidate operations, thereby lowering cost through economies of scale."
Is just a naive way of saying monopolies are good because they will skip the profit motive and pass the cost savings on to the customers.

[Social Construct]

That absolutely tears it for me. Since I am no financial whiz, or have much book learnin' on the subject of economics, I've deferred to some of the more moderate of "experts", even when what I could understand of their econo-speak seemed antithetical to common sense and the everyday dealings of getting along in contemporary society. No more. This entire article, excepting the fact that the older, disregarded regulatory stops against fraud and abuse worked, is speculation that would put this nation's people back into the dark tunnel we've been guided into by the people that mapped the economic destruction we find ourselves trying to claw our way out of. These obstructionists to what is decent, ethical and just plain right about regulating the heck out of the thieves of Wall Street is wrong, absolutely wrong. Do you hear?

[uncleentropy]

I don't think we can let any bank or investment house securitize the mortgage debt obligations and sell them. We can make underwriting standards as strict as we want to, but if given the chance to sell off the risk, lenders will sign up lots of unqualified people for mortgages. They will find a way around the standards because it means so much money to them.

Perhaps no one has an appetite for mortgage-back derivatives now, but we need to bury that idea. If the return of GS would not do that, then I want more....call it "Glass Plus" we we segregate banking and investment AND we severly restrict debt commoditization.

[blueken]

One could say that restricting people from selling smoke and mirrors prevents financial institutions from engageing in fraud for profit. Free from regulations, these institutions could use the "invisble hand of the market place" to touch ordinary citizens in some very uncomfortable places. While that would be disagreeable to many hard working people, it would enable top executives at these institutions to improve the income gap, therebye allowing those executives to purchase walk-in closets with crown moulded granite counter tops and plazma TVs in the Hamptons. Therebye stimulating Chinese manufacturing. Now who could argue with that outcome? Certainly not me.

[iridium53]

The drawback you note, however, is only a drawback for the banks and their profits.

The services offered could easily be obtained from a set of companies, just as it was from 1932 until 1999.

Segregation and control of risk served the country well for 67 years.

Since 1999, uncontrolled bankers ran the risk levels up - and instigated the largest collapse since the Great Depression - that seems to have been averted only by government intervention with huge injections of taxpayer money.

While bankers like the idea of a free market economy, it's not much of a free market if the taxpayer must bail out the bankers - certainly not free to the American taxpayer who will be paying off the bankers debt for generations. Bankers were unaffected by this because the American taxpayer were forced by the government to cover their gambling debts,

You' seem to be arguing that we should continue to do the same things with the same people. That, somehow, the same people with the same tools will get a different result. That's nonsense.

Albert Einstein once said “The definition of insanity is doing the same thing over and over again and expecting different results”.