I had the pleasure of being in the audience for a panel of Albany Law School alumni that work as lawyers in the financial industry. The panelists included legal counsel for Jamie Dimon (hereafter LJD), in-house counsel for Bank of America, a Vice President and in-house counsel for a medium-size financial firm, and legal counsel for an international mutual fund, with offices in America and Germany.
Inevitably (as you might imagine), the question of too-big-to-fail institutions came up, as well as the efficacy of Dodd-Frank. The recent collapse of MF-Global also came up as well. Everybody has nuanced opinions on Dodd-Frank (the consensus view being that there were some good provisions in it, but that many of them were untested ideas that were already having unintended negative consequences that will find their way back to the pockets of Main Street in one way or another).
Two things caught my attention during the discussion:
1. The collapse of MF Global. The LJD panelist mentioned that MF-Global was not a bank, and so they could not rely on the Fed as a lender of last resort to maintain liquidity. He also mentioned that there was absolutely no reason to bail out MF-Global because they should reap the fruits of their bad bets, i.e. Capitalism always has winners and losers, and the losers should be allowed to fail. Otherwise, the taxpayers are on the hook for those bad bets. HOWEVER, the LJD panelist also mentioned that he felt the Fed plays an absolutely vital role in our financial system, because it is the only financial institution with the policy tools capable of responding to the types of systemic risk that materialized, say, during the 2008 Crisis; or that may arise due simply to the fact that financial markets are global, and a lack of unity in twin areas of monetary and fiscal policy necessarily leads to imbalances that need to be addressed. He pointed specifically to the Euro-zone crisis as evidence that 1) non-unity between monetary and fiscal policy can have disastrous effects, and 2) the absence of a lender of last resort has left several European governments in crisis, which negatively impacts all countries who use the Euro.
2. Bank of America’s derivatives shuffling. A member from the audience asked counsel for Bank of America (BoA) about the recent decision to move $53 trillion in derivatives to one of its holdings divisions which is insured by the FDIC. This arises from the fact that this division has $1 trillion in deposits that serve as a back-stop for the $53 trillion. What that means is that, because the division is a deposit-holding institution, all of its assets are insured by the FDIC. This has created an interesting dissonance between the Fed, who supports the measure on the basis of soundness, and the FDIC, who doesn’t have anything approaching the assets necessary to insure $53 trillion in derivatives. The BoA panelist said that he couldn’t get into too many details about the transaction (since he is a lawyer and has a duty of confidentiality), however, he said that BoA was aware that the transaction was controversial, and said that they specifically designed the transaction so all of the assets were “riskless,” i.e. it was largely a cosmetic transaction obviated by the fact that Moody’s recently down-graded BoA’s Merill Lynch unit to Baa1, three steps above junk status.
In response to these two issues, two things came to mind:
1. 'Riskless' transactions. The idea of something being a “riskless” transaction is problematic to me. The derivative-trading strategies that led to the financial crisis were developed on the basis of Algorithms known as Gaussian Copulas, which were supposed to eliminate the risk of financial loss to an infinitesimally small margin, such that profitability was virtually ensured. The problem is that the designers of the Gaussian Copula never accounted for what would happen if those investments did fail. It turns out that all the Copula was doing was accumulating those infinitesimally small risks into ever-growing complex securities that investors packaged based on a false assumption: that each infinitesimally small risk was independent of the other, and would never come to pass. We all know how well that worked out.
2. 3-part problem. Based on everything I’ve mentioned so far, I see three problems that are being identified by the panelists:
a) Too-big-to-Fail institutions
b) The ability of Banking institutions to use the FDIC to insure investment instruments rather than deposits.
c) The ability of banks who have combined investment and deposit-holding functions to use the Fed as a lender of last resort (which only deposit-holding institutions can do, hence why MF Global couldn’t rely on the Fed as a lender of last resort to prevent its collapse).
We did not need Dodd-Frank to solve these problems. I agree with the panelists that Dodd-Frank is a smorgasbord of good intentions and untested provisions that have wide-reaching and unintended consequences. Every single one of these problems could be solved by re-instating Glass-Steagall.
Why We Should Reinstate Glass-Steagall
I’ll borrow from Wikipedia for the definition and brief history:
The Banking Act of 1933…was a law that established the Federal Deposit Insurance Corporation (FDIC) in the United States and introduced banking reforms, some of which were designed to control speculation. It is most commonly known as the Glass–Steagall Act…Provisions that prohibit a bank holding company from owning other financial companies were repealed on November 12, 1999…
The repeal of provisions of the Glass–Steagall Act by the Gramm–Leach–Bliley Act in 1999 effectively removed the separation that previously existed between investment banking which issued securities and commercial banks which accepted deposits. The deregulation also removed conflict of interest prohibitions between investment bankers serving as officers of commercial banks. This repeal may have contributed to the severity of the financial crisis of 2007–2011 by allowing banks to become so large, complex, and intertwined that both they and their regulators failed to see the systemic risk that a failure in one part of one bank could lead to cascading failures across the global financial system.
If we re-instate Glass-Steagall, all of the big banks, as we know them, would cease to exist in their current form. Understand what this would do:
1. Investment banks would no longer be able to use the Fed as a lender of last resort by virtue of being simultaneous deposit-holders. That means the Fed is no longer underwriting the bad bets of large institutional investment firms. It means that if JP Morgan makes bad investments, it goes the way of MF Global.
2. Bank of America would no longer be able to move $53 trillion in derivatives into an FDIC-insured holding subsidiary, because it could no longer simultaneously be a deposit-holding institution and an investment bank.
3. The immediate separation of deposit-holding and investment functions, and the foward-moving prohibition on any firm conducting both functions at the same time, would shrink the size and exposure of every single large institutional financial firm virtually overnight. Becoming too-Big-to-Fail becomes difficult if not impossible under Glass-Steagall.
Glass-Steagall was repealed in 1999, and bi-partisan proposals to re-instate it were introduced in 2009. Unfortunately, a half-measure, known as the Volcker Rule, was introduced into Dodd-Frank. It’s better than nothing, but it fails to address the systemic problem: financial institutions have an incentive to combine deposit-holding and investment functions under one flag, for reasons stated above. Those incentives, however, revolve around the bank’s personal interest, and not the systemic exposure that inevitably accompanies merging the investment and deposit-holding functions of two firms into a single entity.
Instead of passing 1,000 pages of new regulation, we should just pass a fairly simple regulation that was repealed in 1999 so that large firms could increase their capital flows and exposure (and thereby make more money in the process).
We should repeal Dodd-Frank and re-institute Glass-Steagall. Many of the systemic problems that caused the 2008 financial crisis would be eliminated by separating the deposit-holding and investment banking functions on Wall Street. We don’t need a megalith like Dodd-Frank when we can solve the same problem with a smaller, simpler, concise, easy-to-apply regulatory framework like Glass-Steagall.