So here's my take on
Glass-Steagall... with some back-story.
There's quite a bit of misinformation floating around right now so I feel like it's necessary to clear a few things up.
Glass-Steagall was originally introduced in 1933 to try and separate banks and securities firms. The reason for this, was simply to keep banks from over-leveraging themselves and putting deposits at risk... I should go back further.
Where Banks make money.
Banks create an incentive for you to deposit funds at their institution through the payment of interest and the production of some kind of utility such as checking services and the like. With your deposits, they bet that you're not going to need to take ALL of your money out right away, so they loan those funds out to others as another service – Providing credit (liquidity) to borrowers be it a business or a person and for a multitude of things. Business loans for development, home loans, personal lines of credit etc. etc. They in turn collect interest on the loans which is how they generate a profit (and in turn pay for services they provide to you, the depositor.)
On a balance sheet, this means that the money you deposit is a liability to them (since you can take it out at any time) and a loan is an asset. Loans are traditionally backed by collateral that the bank can use to recoup its losses should someone default on the loan. Because of this, and the promise to repay a loan with interest, these loans are assets to the bank – They're expected future revenue.
A bank run occurs when people lose faith that their financial institution will remain solvent (that is, that you'll be able to get your money back if you want it) and so they all rush to the bank to take their money out. Since your money has been loaned off to someone else, only the first few people who get there and deplete what cash reserves they have will actually be successful and ultimately, you lose your money because the bank put it at risk. Over the course of over a century, banks have been finding new ways to increase their profit on the money you leave on deposit. One of those ways is through the purchase and sale of securities with your dollars. These could be bonds, stocks, default credit swaps, futures contracts, buying securitized debt, and other things.
So, Glass-Steagall. The point of the legislation originally enacted in 1933 was to prevent banks from also becoming securities traders, ultimately with the hope of limiting risk to the depositors and therefore, the risk of financial collapse. But what does financial collapse mean?
Well, typically we think of financial collapse as a decrease in overall liquidity. That is, people stop buying, start saving and holding wealth or buying assets because money itself is being exchanged for goods less frequency (two aspects, one is the availability of credit, the second is a decrease in the velocity of money – how often it's exchanged.) We mostly focus on the availability of credit... but not to consumers in the traditional sense. Since banks loan out your deposits to make a profit, banks will do so as long as it continues to be profitable. If the risk of issuing loans increases, it will cease to issue loans (a credit freeze.) Fewer loans means less investment by business on future projects, and also fewer home loans, auto loans, etc. In addition to this, banks are required by law to maintain certain cash reserves (in the case people do want to take their money out.) Often times if lending is profitable, banks will borrow from each other at the federal funds rate – They can loan money to you for a higher interest rate than they will pay to another bank.
When we hear talk about keeping the federal funds rate low it is usually a measure to ensure a high level of liquidity in the market place to promote lending which generally stimulates production in the economy (a rise in the GDP.)
It also increases risk (which on a large scale, results in collapse.)
I digress... Glass-Steagall's object as I mentioned before, was to prevent banks from over-leveraging deposits through securities acquisition. The issue with the legislation is that it wasn't very effective. It prevented banks from directly selling securities to individuals and also developing or owning a securities division of itself, but it didn't prevent securities firms from owning banks. The legislation was so weak, that by the 1960's basically no one paid attention to it anyway since there were so many loopholes. And then came GLBA, the Gramm-Leach-Bliley Act which basically eliminated the provisions of Glass-Steagall, in 1999.
Some folks in the media are arguing that we had no problems during the days of Glass-Steagall which is unfortunately false. Savings and Loan institutions are legally different from banks and were completely unaffected by Glass-Steagall. In 1983, we had a massive issue with S&L institutions that caused a (comparatively) minor collapse at that time. (Strangely enough, John McCain(R-AZ) was involved in the collapse with a group called the Keating Five. Now, he's one of the biggest advocates of renacting Glass-Steagall.) So, there's a lot of questionable info and theories about what it actually achieved.
Here's my issue. Glass-Steagall may be all well and good, but it doesn't solve the problem. Banks used to operate on what's called a “Lend and Hold” model. That is after they issued the loan, they'd hold on to that loan for expected repayment. If you went to a bank for a loan, they frisked you pretty hard before approving the loan because they wanted to be sure you'd pay it back. Over time, securities firms (and largely organizations like GNMA (Ginnie Mae), FNMA (Fannie Mae) and FHLMC (Freddie Mac)) started “securitizing” loans. That is they'd sell the expected interest gains to investors as part of an investment package; A “Mortgage Backed Security.” If you were an investor, you'd buy part of the loan debt with the expectation of getting paid interest and repayments of your initial principle. Over time, these mortgage backed securities began being sold and bought between investment houses and often times packaged and resold so many times that the original banker's risk analysis they performed when they issued the loan is unknown to anyone.
Since these banks were making money on loan origination fees (points) and then selling off the debt, there was no incentive not to double-check the potential borrower and it even created incentive to issue loans the banks knew were bad. This new model is called “Lend and Sell" and it's still how banks operate today.
So. To me the issue is securitization of debt. Glass-Steagall does claim to attempt to resolve much of that, but the bill would have to be ridiculously comprehensive and it would also come at the risk of damaging what I mentioned before – Liquidity. Credit availability would decrease, and it would decrease more for at-risk borrowers (read, the less wealthy and financially unstable.) That being said, I think the real solution isn't an easy one that a simple bill limiting the securities holdings of financial institutions is going to achieve. Especially when one of the largest organizations buying mortgage backed securities is actually a government institution that has been charged with mitigating the impact of toxic loan assets on the financial system, Ginnie Mae. Ultimately I am behind reenacting Glass-Steagall but I do not believe it will be a complete or even modestly sufficient solution, simply a step in the right direction.
Compare the securitization of debt, with an equity instrument like a stock. One is an at-risk asset by definition, the other is an ownership interest in a company. Both are securities, the difference is where and how the risk is held.
As long as at-risk debts can be securitized and re-sold there will always be an incentive for this "lend and sell" style of banking since that risk can be hidden from potential investors.
There's quite a bit of misinformation floating around right now so I feel like it's necessary to clear a few things up.
Glass-Steagall was originally introduced in 1933 to try and separate banks and securities firms. The reason for this, was simply to keep banks from over-leveraging themselves and putting deposits at risk... I should go back further.
Where Banks make money.
Banks create an incentive for you to deposit funds at their institution through the payment of interest and the production of some kind of utility such as checking services and the like. With your deposits, they bet that you're not going to need to take ALL of your money out right away, so they loan those funds out to others as another service – Providing credit (liquidity) to borrowers be it a business or a person and for a multitude of things. Business loans for development, home loans, personal lines of credit etc. etc. They in turn collect interest on the loans which is how they generate a profit (and in turn pay for services they provide to you, the depositor.)
On a balance sheet, this means that the money you deposit is a liability to them (since you can take it out at any time) and a loan is an asset. Loans are traditionally backed by collateral that the bank can use to recoup its losses should someone default on the loan. Because of this, and the promise to repay a loan with interest, these loans are assets to the bank – They're expected future revenue.
A bank run occurs when people lose faith that their financial institution will remain solvent (that is, that you'll be able to get your money back if you want it) and so they all rush to the bank to take their money out. Since your money has been loaned off to someone else, only the first few people who get there and deplete what cash reserves they have will actually be successful and ultimately, you lose your money because the bank put it at risk. Over the course of over a century, banks have been finding new ways to increase their profit on the money you leave on deposit. One of those ways is through the purchase and sale of securities with your dollars. These could be bonds, stocks, default credit swaps, futures contracts, buying securitized debt, and other things.
So, Glass-Steagall. The point of the legislation originally enacted in 1933 was to prevent banks from also becoming securities traders, ultimately with the hope of limiting risk to the depositors and therefore, the risk of financial collapse. But what does financial collapse mean?
Well, typically we think of financial collapse as a decrease in overall liquidity. That is, people stop buying, start saving and holding wealth or buying assets because money itself is being exchanged for goods less frequency (two aspects, one is the availability of credit, the second is a decrease in the velocity of money – how often it's exchanged.) We mostly focus on the availability of credit... but not to consumers in the traditional sense. Since banks loan out your deposits to make a profit, banks will do so as long as it continues to be profitable. If the risk of issuing loans increases, it will cease to issue loans (a credit freeze.) Fewer loans means less investment by business on future projects, and also fewer home loans, auto loans, etc. In addition to this, banks are required by law to maintain certain cash reserves (in the case people do want to take their money out.) Often times if lending is profitable, banks will borrow from each other at the federal funds rate – They can loan money to you for a higher interest rate than they will pay to another bank.
When we hear talk about keeping the federal funds rate low it is usually a measure to ensure a high level of liquidity in the market place to promote lending which generally stimulates production in the economy (a rise in the GDP.)
It also increases risk (which on a large scale, results in collapse.)
I digress... Glass-Steagall's object as I mentioned before, was to prevent banks from over-leveraging deposits through securities acquisition. The issue with the legislation is that it wasn't very effective. It prevented banks from directly selling securities to individuals and also developing or owning a securities division of itself, but it didn't prevent securities firms from owning banks. The legislation was so weak, that by the 1960's basically no one paid attention to it anyway since there were so many loopholes. And then came GLBA, the Gramm-Leach-Bliley Act which basically eliminated the provisions of Glass-Steagall, in 1999.
Some folks in the media are arguing that we had no problems during the days of Glass-Steagall which is unfortunately false. Savings and Loan institutions are legally different from banks and were completely unaffected by Glass-Steagall. In 1983, we had a massive issue with S&L institutions that caused a (comparatively) minor collapse at that time. (Strangely enough, John McCain(R-AZ) was involved in the collapse with a group called the Keating Five. Now, he's one of the biggest advocates of renacting Glass-Steagall.) So, there's a lot of questionable info and theories about what it actually achieved.
Here's my issue. Glass-Steagall may be all well and good, but it doesn't solve the problem. Banks used to operate on what's called a “Lend and Hold” model. That is after they issued the loan, they'd hold on to that loan for expected repayment. If you went to a bank for a loan, they frisked you pretty hard before approving the loan because they wanted to be sure you'd pay it back. Over time, securities firms (and largely organizations like GNMA (Ginnie Mae), FNMA (Fannie Mae) and FHLMC (Freddie Mac)) started “securitizing” loans. That is they'd sell the expected interest gains to investors as part of an investment package; A “Mortgage Backed Security.” If you were an investor, you'd buy part of the loan debt with the expectation of getting paid interest and repayments of your initial principle. Over time, these mortgage backed securities began being sold and bought between investment houses and often times packaged and resold so many times that the original banker's risk analysis they performed when they issued the loan is unknown to anyone.
Since these banks were making money on loan origination fees (points) and then selling off the debt, there was no incentive not to double-check the potential borrower and it even created incentive to issue loans the banks knew were bad. This new model is called “Lend and Sell" and it's still how banks operate today.
So. To me the issue is securitization of debt. Glass-Steagall does claim to attempt to resolve much of that, but the bill would have to be ridiculously comprehensive and it would also come at the risk of damaging what I mentioned before – Liquidity. Credit availability would decrease, and it would decrease more for at-risk borrowers (read, the less wealthy and financially unstable.) That being said, I think the real solution isn't an easy one that a simple bill limiting the securities holdings of financial institutions is going to achieve. Especially when one of the largest organizations buying mortgage backed securities is actually a government institution that has been charged with mitigating the impact of toxic loan assets on the financial system, Ginnie Mae. Ultimately I am behind reenacting Glass-Steagall but I do not believe it will be a complete or even modestly sufficient solution, simply a step in the right direction.
Compare the securitization of debt, with an equity instrument like a stock. One is an at-risk asset by definition, the other is an ownership interest in a company. Both are securities, the difference is where and how the risk is held.
As long as at-risk debts can be securitized and re-sold there will always be an incentive for this "lend and sell" style of banking since that risk can be hidden from potential investors.
