03/07/2011 04:41 pm ET Updated May 25, 2011

The Knotty Problem of Partial Regulation

My recent review of Amar Bhidé's book "A Call for Judgment," which makes the so-called utility bank argument -- an updated Glass-Steagall split between regulated depository institutions and more lightly regulated risk-taking firms -- raises an issue that has been overlooked: the unintended consequences of partial regulation. Today there's sensitivity to the dangers of regulatory arbitrage when regulatory regimes widely vary either nationally or internationally -- although, so far, there are few answers to resolve this beyond gestures toward coordination. But the nostalgia for Glass-Steagall, and for the era in which commercial and investment banking remained chastely separate, has produced a kind of amnesia about its long decline and eventual repeal. The often-forgotten lesson of that decline is the sheer difficulty of trying to shield a vital sector of any industry from change and risk, to put it under glass.

The issue here takes us to some of the toughest questions in financial regulation. How responsible was the post-New Deal split in finance, with its heavy regulation and its rigid approach to what banks and firms could sell, what they could charge and where they could operate, for the bountiful growth of the '50s and '60s? Could we replicate such an old-fashioned (the term is Bhidé's and is meant positively) banking system today and drive the modern, globalized, diverse economy of 2011? What we know about the '50s and '60s, besides the fact that the economy boomed, is how moribund and tiny Wall Street was. The real economy was dominated by a relatively small number of large corporations -- mechanisms to fund startups or finance the middle market were nascent, at best -- which were either self-funding or that had long-term banking relations when borrowing was necessary. Wall Street catered mostly to individual investors. The notion of a Wall Street club was not an exaggeration; it operated as a kind of fixed-price cartel, with little competition and great inefficiencies.

While there were two differentially regulated sectors of finance -- commercial and investment banks -- neither displayed much in the way of dynamism. That was partly because regulation in terms of the commercial banks, and mostly self-regulation in terms of investment banks, resisted innovation. The situation only began to change in the late '60s with the entrance of institutional investors demanding greater efficiency, more competition and greater use of technology; the institutional critique took on bite with '70s stagflation and Wall Street's meltdown in the back-office crisis. The breakup of the old New York Stock Exchange-dominated Wall Street and the rise of a new, publicly listed, profit-seeking Wall Street firm shattered three decades of Glass-Steagall peace and quiet. These new firms began to compete with the banks. They began to develop new products, like junk bonds, that deepened and broadened markets. They brought an ideology of free markets and financial innovation with them. The old ways, including the partnerships, got tossed. The modern cult of performance emerged.

Much of what Bhidé writes about in his book, including the emphasis on liquidity and the rise of arm's length shareholding, then developed. Many of these developments certainly seemed necessary and commendable at the time; some still do, though we look at this period now with a new, more critical, perspective.

What's clear is that the banks came under siege. And the long mutual jockeying between Wall Street and banking began, with regulators on each side stepping in to liberalize rules for their "team." The Federal Reserve, which regulated many of the banks, clearly saw that danger to the banks and to its own control over the economy, which is exerted through banks. Regulators also recognized how globalization was accelerating and favored bank consolidation, which gave some of the biggest banks the scale to compete globally. And once begun, the process of hollowing out Glass-Steagall with waivers, exemptions and allowances took off, all in the name of efficiency and competitiveness.

Eventually Glass-Steagall fell. By then, 1999, deregulation had taken on a life of its own.

What's this have to do with utility banks? The real question is: What's different today? If you tightly regulate utility banks, how will they compete? If they remain public companies, they will clearly be afforded lower multiples than risk-taking Wall Street firms or hedge funds. The businesses that utility banks will operate in -- mostly relationship lending to corporations and individuals -- are effectively commoditized. Without scale, those commodity products will create fragility among smaller banks that could prove disastrous (see the S&Ls) in the wrong market. Talent will be difficult to find. You may be able to recreate a more accountable credit culture that involves long-term relationship lending, but the compensation undoubtedly won't compare to the higher fliers. (One possible analogy: Utility banks are like credit rating agencies.) Moreover, why wouldn't the kind of disintermediation that occurred in banking in the '70s and '80s -- the loss of business to more lightly regulated, market-oriented rivals -- return?

What are your choices? Well, there are two roads: more regulation and less. Both tend to be self-fulfilling. You can deregulate the utility banks to allow them into businesses that can make them some money and restore some dynamism. Of course, that's exactly how we ended up repealing Glass-Steagall in the first place. Or we can re-regulate firms in ways that try to even the playing field, by, say, coming up with new rules that restrict Wall Street firms. But regulatory arbitrage being what it is, and the stakes being what they are, you may not be able to stop until the two sectors are essentially at the same level. That period of "leveling" could be a dangerous one. Utility banks may well have few options to seek greater profits -- but then they said that about the S&Ls too. And Wall Street will do what it does best: It will frantically seek profits in new areas, while seeking more risk and leverage. In which case, you have to ask yourself: What good is it to have a relatively deregulated financial sector?

Besides, even if you seal off utility banks and deposits from danger, a large systemically vital firm can wreak the kind of damage that will engulf Main Street. Deposits and payments were not really damaged in the financial crisis, and yet Main Street is still suffering.

Now perhaps it is possible to seal off utility banks in such a way that they can provide competitively priced services and not blow themselves up. Perhaps there is a way to fund these banks without public listings, which (as we just saw) may nurture recklessness. And perhaps utility banks can satisfy the needs of individuals and companies. If that's the case, then perhaps we finally have a case where partial industry regulation actually works over the long term, unlike telecom, healthcare, airlines or banking.

That would be wonderful. That might provide at least a partial solution to the toxic conundrum of too-big-to-fail and moral hazard. There's just no evidence that it's true.

Robert Teitelman is editor in chief of The Deal.

For more from Robert Teitelman, check out The Deal Economy.