Out of the Shadows:

Creating a 21st Century Glass-Steagall

Raj Date and Michael Konczal

The Cambridge Winter Center for Financial Institutions Policy, in conjunction with the Roosevelt Institute’s conference on financial regulatory reform entitled “Make Markets Be Markets”, is pleased to present this research note.  The piece, which appears as a chapter in the conference’s materials, is co-authored by Cambridge Winter’s Executive Director Raj Date, and Roosevelt Institute Fellow Michael Konczal.

The paper argues that the link between the financial crisis and the relaxation of Glass-Steagall’s constraints is rather more complicated than typically understood. 

The Gramm-Leach-Bliley Act, the financial reform legislation passed in 1999, implicitly relied on an internally consistent set of logical premises:  (1) that widening the scope of banks’ activities would allow them to reverse a long-term secular decline in competitiveness; (2) that non-depository “shadow banks” should continue to compete in the banking business, because free market discipline would force them to make sound credit risk-return decisions; and (3) that even if shadow banks failed to make good credit decisions, their resulting bankruptcies would not result in taxpayer harm.

To most policy-makers at the time, those premises seemed sound.  But in hindsight, all three premises have proven disastrously false in the marketplace. 

Except for the few largest bank holding companies, the opportunity to enter the securities business has not made banks any more competitive.  Moreover, it turns out that non-banks (e.g. Merrill Lynch, GE Capital, CIT, GMAC, the GSEs) made breathtakingly bad credit risk-return decisions.  And the lack of any bank-like regulatory governors on growth allowed leading shadow banks to grow so explosively during the credit bubble that, when they failed, taxpayers were forced by two successive Administrations to support them, for fear of the collateral damage of such large firms’ collapse.

Congress did not create the crisis through the 1999 deregulation.  But by focusing on the deregulation of banks, instead of managing the already growing systemic risk of the shadow banks, Congress not only enabled the financial crisis, it may well have hastened it. 

In light of that experience, policy-makers should now focus on a new kind of Glass-Steagall -- one that prevents shadow banks from creating the same kinds of risks again.