Glass-Steagall is Dead – Get Over it.

By Frances Coppola, Proprietor, Coppola Comment

Glass-Steagall is dead. Rather like Soviet-era Communist leaders, it has been officially dead since 1999, and actually dead for much longer. Though there was no state funeral, the body was not embalmed or put on display and few people mourned its passing.

Well, not at the time. But fast forward to 2008 and suddenly the Western world – not just the US – exploded in a paroxysm of grief over the demise of Glass-Steagall. “If only Glass-Steagall hadn’t been repealed!” people cried. “Glass-Steagall would have prevented all these banks failing. Glass-Steagall would have stopped all these derivatives being created. Glass-Steagall would have protected everyone’s money”. Glass-Steagall, it seems, could have prevented the entire financial crisis. Never mind that Lehman, Bear Sterns and Merrill Lynch were pure investment banks, with no retail deposits to put at risk. Never mind that AIG was an insurance company and Fannie and Freddie were government-sponsored enterprises – none of which were subject to Glass-Steagall’s provisions. Never mind that Countrywide and most of the other mortgage originators that together created the largest fraud in US corporate history were pure retail lenders and therefore ALSO not subject to Glass-Steagall’s provisions. And never mind that the large universal banks in the US survived the financial crisis relatively unscathed – which might not have been the case if Glass-Steagall had prevented them diversifying.

Ever since, there have been calls for its resurrection in some form or another. The UK is adopting a baby Glass-Steagall. The Eurozone is thinking about a gauzy curtain. And the US has brought in a distant relative – the Volcker Rule. But people are not happy. “WE WANT GLASS-STEAGALL! BRING BACK GLASS-STEAGALL!” they cry. Bizarrely, even people in the UK cry this. The UK never had Glass-Steagall. I wonder sometimes if people really understand what it is they are demanding.

Four years on, there is still an immense amount of nostalgia for the age of Glass-Steagall. And there are repeated attempts to bring it back in some form. The latest attempt is by Senators Warren, Cantwell, McCain and King. Warren admits that Glass-Steagall would not have prevented the financial crisis, and would not end “too big to fail”, but none-the-less wants the large universal banks to be forced to divest their investment banking activities, apparently in order to improve the “culture” in retail banking. But as I’ve noted before, the cultural shift in retail banking away from service and towards aggressive product selling had nothing to do with investment banking: it long pre-dated the repeal of Glass-Steagall and was due to low margins and cut-throat competition in the retail banking sector.

Warren – like many others – wants separation of investment banking from retail to prevent “insured deposits” being used to fund risky activities. Sadly that demonstrates a total lack of understanding of the real funding problems in the financial crisis, or indeed of the nature of bank lending. The problem was actually that wholesale funding – which is prone to runs, as I shall explain – was excessively relied upon to fund risky activities, including retail lending. Retail lending may be “boring”, as Warren claims, but it isn’t “safe”. Deposits that back retail loans on bank balance sheets are at risk. If they are insured, that puts taxpayers’ money at risk just as much as if those deposits were used for securities purchase.

Nevertheless, the calls for separation of “boring” retail banking from “risky” investment banking continue. And there is an important issue here. It concerns the extent to which we are prepared to provide public funds to support the activities of banks. In essence, Glass-Steagall and all its relatives are an attempt to limit the activities that can be supported by public funding – by which what people really mean is liquidity support from central banks.

The trouble is that this is actually impossible. When investment banks are separated from commercial banks they become their customers. Their cash balances sit in commercial banks, because ALL money that isn’t in the form of physical notes and coins sits in commercial banks, one way or another. All financial market trading is intermediated through commercial banks. All new stock issues are intermediated through commercial banks. Payment fails don’t just affect the recipients, they affect the liquidity of the banks through which they are intermediated. In practice it is simply impossible to remove liquidity support from payments arising from market trading, and very dangerous to attempt it – as the Fed discovered when Lehman fell. Remove central bank liquidity support for market trading activities and the entire market collapses like a house of cards.

There is a prevalent belief that if a Glass-Steagall separation were imposed, financial markets could be allowed to collapse without commercial banking being affected. This is completely wrong. When major customers of commercial banks fail, the banks themselves are at risk – and by extension so are their retail customers. The Lehman collapse and consequent market freeze very nearly caused the failure of the global payments network, which would have had catastrophic effects on retail customers. Central banks have to provide liquidity support for ALL payments, whatever their source, not to protect investment banks but to protect the retail customers of commercial banks.

It’s not enough to provide liquidity support after the event, either. Perception of liquidity support is really important. It is the perception of illiquidity that causes bank runs. Institutional investors are nervous creatures. If they believe they might lose access to their funds, they will pull them. Note that this has nothing to do with whether or not there is a real risk of actual loss: even if lending is collateralised with good quality assets there can still be runs. When funding stresses make headline news and there is no apparent liquidity support, people pull their money from the banks affected. So when investment banks are denied liquidity support, institutional investors will pull their funds if they smell trouble – and the knock-on effect is a run on commercial banks, since investment banks are customers of commercial banks. Admittedly, all that really happens in a modern bank run is that money moves from one commercial bank to another – but large unexpected flows of money are destabilising for the banking system as a whole and can be fatal for individual commercial banks.

Liquidity management for commercial banks is a huge issue. Regulatory pressure at the moment is pushing them to increase their holdings of liquid safe assets such as government debt and to fund themselves more with retail deposits than wholesale funds. Retail deposits have traditionally been slower to run than wholesale funds: in the past this has been partly due to retail customer apathy, and partly because retail depositors have had to wait for banks to open in order to withdraw their money, whereas institutional investors can move their money by trading overnight on Far Eastern markets. But this difference is disappearing fast as internet banking makes it possible for retail customers to make payments and move money around at any hour of the day or night. If you make it easier for people to move their money, they are more likely to do so.

Matthew Klein thinks that separating deposits from lending would solve the problem, because it would mean that deposits were never used to fund risky lending. Most bank deposits are moving balances. There are payments in and out of transaction accounts of all kinds all the time: some of those are retail transactions and others come from institutional or market sources. It is not realistic to say “we will provide liquidity support for transactions from retail sources but not from wholesale ones”. The same banks are at risk from payment fails whatever the sources of the transactions, and therefore so are their customers. Klein wants to protect all deposits, irrespective of their size or origin, by backing them with central bank reserves – which neatly solves the transactions problem, but falls foul of popular abhorrence of public support for large institutional, corporate or high-net-worth individual deposits.

Of course many market trades are never cash settled. And it might be assumed therefore that they do not affect commercial banks. This would be wrong. Many of them have cash margin. And cash margin is held in banks. One way or another, all money is held in commercial banks, and it isn’t in practice possible to distinguish between different “pots” of money in the provision of liquidity support, as proponents of structural reform (of all kinds) seem to think. Money is money, whatever its source: if it disappears in transit – whether because of customer default, market freeze or payment system failure – its absence causes problems for both the recipient customers and their banks.

Ensuring the smooth operation of payments has become the primary purpose of central bank liquidity, because advanced economies have allowed themselves to become completely dependent on commercial banks to facilitate the vast majority of cash transactions. Separating out different bits of banking would not eliminate this need: all it would do is create the impression that some types of transaction would not be supported, which would increase the likelihood of highly damaging market freezes or runs even though post-Lehman no central bank would dare withdraw liquidity support for non-retail transactions.

The problem it seems to me is that we have universal access to payments through the same set of commercial banks. There might indeed be a case for completely separating retail (insured) deposit-taking from everything else, perhaps in the form of a new public utility, but it would have to have its own payment systems directly supported by central banks. Would this eliminate the need for central bank liquidity support for non-retail transactions? I’m not sure, frankly. I suspect that even if retail payments were separated from wholesale in this way, there would still be untoward economic effects from financial market failure, which would hurt Main Street just as much if not more than losing their deposits. Hatred of all things non-retail is not sufficient justification for systematic dismantling of central bank support. The economic impact of such an act needs to be fully understood – which at the moment it is not.

What is clear though is that a 1930s-style separation of retail and investment banking is meaningless while all payments go through the same set of commercial banks. We forget that there were no payments systems in the 1930s. Everything was settled in physical cash. Do we really want to go back to that?

Glass-Steagall is dead. It is not appropriate for our modern banking system. Grieve for a bygone age, and move on.


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Frances Coppola

Frances Coppola

In a past life I worked for I write about them. Actually I write about finance and economics generally. And about anything else that interests me - so you may occasionally find posts on this site that have nothing to do with banking, economics or finance. In fact they might have something to do with music, since I'm a Associate of the Royal College of Music and a professional singer and teacher. I'm also an alumnus of Cass Business School, where I did an MBA with a specialism in finance and risk management

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  • Cowpoke

    It’s the same tired old knee jerk rhetoric. Glass-Steagall was in tact during the tumultuous 1980’s savings and loans troubles.

    Just like The “Brady Bill” was in tact during the Columbine massacre.

    However, politicians seek to make a name for themselves simply because they have high cheek bones.

  • Tyler

    Elizabeth Warren already made a name for herself by trying to warn about derivatives before most people even heard about them or the financial meltdown.

    Glass-Steagall was apart of a stable banking system for 50 years before the 1980s savings and loans troubles. You can’t say Glass-Steagall failed during the 1980s, because as usual, regulations were rolled back leading up to that crisis.

    Barry Ritholtz has been all over this:

  • marketfowl

    So we’re good with moral hazard then?

  • bart

    Irrational exuberance too. /sarc

    And another vote for Ritholtz truth, and Warren’s efforts. She succeeded against all odds on the CFPB, so counting her out is unwise.

  • jswede

    FDIC insured hedge funds……

  • jswede

    poorly run, I should add

  • Lee Colville

    And what is her suggestion for improving the system?

  • smob

    Sorry this time you did not do your home work! Many countries separate commercial and investment banks quite successfully and those countries did not go through a banking crisis…surprise, surprise guess why?

  • Martin T

    The best book around about banking regulation is according to me Anat Admati and Martin’s Hellwig’s masterpiece “The Bankers New Clothes”.

    Very good book.



  • charles fasola

    Another TINA argument from a supporter of extractive finance. Without the dominance of private banking and Wall Street we;re all doomed. None of their activities end up pumping the economy at large. As long as asset prices are inflated everyone should be happy. Never mind the destruction wrought.

  • Cullen Roche

    Charles, you support MMT, right? That means you support private banking. You know that, right?

    One of the reasons I started MR was to eliminate these types of contradictions. Frances, who wrote this article, is actually in favor of public banking. So you might want to explore the authors before talking. Me, I am not sure. MR is not about identifying the optimal system, but explaining what is. We have a bank centric money system. Would public banking be better? I don’t know. But I am open to evidence proving so….

  • JWG

    Completely separating utility banking and insured deposits from the big casino, as Ms. Coppola suggests might be viable, would be an excellent place to start the process of reinstatement of Glass Steagall in its most potent form (before the defanging began). She is correct that the payments system exposes banking to Wall Street even with Glass Steagall in place; however, she fails to see the larger point, which is that we must wean Wall Street’s phony aristocrats off the perverse one way bet, too big to fail and jail culture that is creating systemic rot in America’s economic system. Glass Steagall attempts to isolate the big casino (which is a necessary but high risk part of American capitalism) from socioeconomic supports such as deposit insurance and the business of insurance.

  • Mara

    Possibly one of the worst Op-Ed’s I’ve read.

    I’m super-surprised that she worked for banks in the past, too.

    Cullen, you can be a lot better than this trash.

  • LXDR1F7

    How can deposits be a source of funding to the recipient if they are a liability to the bank receiving the deposit?

  • Kman

    So is her suggestion that there should be two separate payment settlement systems? One for insured deposits and one for investment type activities. It might work if investment banks aren’t allowed to have accounts with commercial banks. But I’m confused is she saying this is the best way to do things or is she like Cullen just trying to explain “what is”?

  • Alex

    Not an impressive piece. What happened on a global scale is that the fee income mania of investment banking infected utility banking. And the so-called safe banking of residential mortgages was re-engineered to generate fee income. Naturally wholesale funding was then relied upon to keep things running white hot. So the analysis is not very good and I have never read anyone else who has come up with this as a global / systemic cause of the financial crisis. It is also disingenuous to say we can never really separate. The difference between a depositor and a co-owner is vast and is basically banking 101, so I am not even going to waste time making that distinction clear.

    Separating disparate businesses has another benefit besides formalizing financial firewalls. Many of the multi-line banks are having chronic problems with this division or that. And I think that is a reflection of the fact that they have become to complex and large to effectively manage. Specialization would likely help with this problem. Also, the U.S. regulatory structure was set up with Glass-Steagal in mind. So we either integrate regulators (interesting it was not done with repeal of GS) or we re-instate GS to get best effect from their efforts.

  • jt26

    Good point about insurance companies. In that industry, history resulted in extensive regulation. Regulation is the key. In fact, AIG`s CDS business was a separate non-regulated business … didn`t work out so well!

  • roger ingalls

    Her arguments about the limitations of Glass Steagall are sound, but her failure to point to the root problem(perverse incentives to grow the financial at the expense of the American economy) without offering a solution is morally repugnant.

    Where would we be today if talented and intelligent authors like Coppola did not oppose slavery, or the disenfranchisement of women, and offer viable alternatives? She SEEMS to be making the case to let Wall Street continue on it’s merry way, as they continue to do, without making any changes at all.

  • Quark

    Spot on. It was not Glass steagall that failed it was the incomprehensible delusion that R Reagan lived under…based on his primitive belief that god lives in all men therefore men are basically good. Glass steagalls authors knew from experience that to the contrary, there are men who prey on others and that is the basis for laws which are useless when not enforce.