03/23/2010 05:12 am ET Updated May 25, 2011

Towards a 21st Century Glass-Steagall

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

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.

21st Century Glass-Steagall

So there's now word that, following the advice of former Federal Reserve Chairman Paul Volcker and others, President Obama will move to take a stronger position on financial sector regulation. From the New York Times:

...The president, for the first time, will throw his weight behind an approach long championed by Paul A. Volcker, former chairman of the Federal Reserve and an adviser to the Obama administration. The proposal will put limits on bank size and prohibit commercial banks from trading for their own accounts -- known as proprietary trading....

"The heart of my argument," Mr. Volcker said, "is who we are going to save and who we are not going to save. And I don't want to save what is not at the heart of commercial banking."

Mr. Volcker has been trying for weeks to drum up support -- on Wall Street and in Washington -- for restrictions similar to those passed in the Glass-Steagall Act in 1933. That law separated commercial banking and investment banking, so that the investment arm could no longer use a depositor's money to purchase stocks, sometimes drawing money from a savings account, for example, without the depositor's knowledge.

Simon Johnson has follow-up questions.

I've been thinking a lot about this approach as a major piece of regulating the financial sector. The point isn't to simply redo what we've already done, because markets change and our government's approach to them needs to change as well. There's an argument that the old conflict between commercial and investment banking is gone, and that having these two types of business lines together now actually creates stability for the firm itself. So the idea is to take the spirit of what has worked in the past and update it to new challenges, and in this sense I like to think of this as a "21st Century Glass-Steagall."

Prop Trading

Prop Trading is when a financial firm uses its client's deposits or borrowed money to invest for its own profit. What many financial institutions have decided to do is take a normal business line and plop a hedge fund in the middle of it. The boring insurers AIG are the leading example of this, but it is everywhere. Many of these hedge funds do very complicated, highly leveraged bets: they bet spreads on bonds will converge a penny, like Long Term Capital Management did; they bet you'll see short-term mean reversion in stocks; they bet that after an earnings announcement by a company there will be "drift" in the stock price for an additional week. (There's more -- we haven't even gotten to volatility estimates.) Chasing these statistical ghosts are all worth a penny or two, but if you are highly leveraged that can be a lot of money earned or lost quickly.

Or they can be doing normal gambling in the marketplace, buying financial instruments that they think will go up or down. Since they are also trading for clients, there is that awkward conflict of interest problem, where you may ask them to underwrite something, or trade for you, and they can also trade themselves ahead of your information.

Here's the question: Should we as taxpayers provide a safety net for either of these activities? I'll leave it up to you as to whether or not prop trading makes markets a better thing; to the extent that it does it is certainly well compensated, and well provisioned for by the private market. What we don't want is internal hedge funds to be leveraging up and gambling using money that comes with a safety net for preventing devastating bank runs that is provided by taxpayers. In any institution, but especially financial ones, money is fungible. So putting up "walls" to silo off these different functions within one company won't help us -- we actually need to spin these functions out.

Conflicts, Other Pieces Needed

And the separate but related question of conflict of interest will be interesting: During the first FCIC hearing last week, Angelides grilled Goldman Sachs CEO Blankfein about whether or not there was a conflict between Goldman's market making desk and their underwriting desk. Blankfein said no, these are never in conflict, while Angelides clearly thought they did. I will withhold saying more until I learn about the press conference, but how these types of conflicts of interests are separated out will be a major piece of concern for financial reform, and something that should be clarified today.

So as we discussed in the previous entry, this is a simple and elegant solution. There's no raising a "rainy-day" TARP-esque fund. There's no trying to second-guess the proper limits for trading for profit within a commercial bank. If you want to be in that space, and get the safety net and stability that comes with it, you have to accept simple terms.

Because if a commercial bank fails, it has access to government mechanisms through the normal FDIC channel. If a prop-trading investment bank fails, it should be wound down in accordance with new financial firm bankruptcy rules. Now note we have to move two other pieces of reform in order to make this credible: we need a system where parties are aware of the derivatives holdings of an investment bank pre-crisis, say through a clearinghouse or exchange, so to make resolution credible and prevent panics. We also need a new resolution authority to handle these firms in a manner that won't destroy the system. Regulating exchanges, and special bankruptcy proceeding for financial firms: we've done this before in the New Deal, we just never upgraded it for a new century, and right now a broken financial sector calls again for these changes.

This post originally appeared on New Deal 2.0