Did Congress learn the right lesson this time?

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Print this page by Robert Powell

Military leaders frequently are accused of “fighting the last war,” using the lessons learned in a previous conflict as their guiding light in the latest fight.

The same kind of “last-war” thinking probably explains Congress’ repeated attempts over the past 80 years to reform the U.S. financial system.  Each new effort seems to be aimed at assuring that never again will the most recent financial crisis happen again. 

The latest example of this cycle is the Dodd-Frank Wall Street Reform and Consumer Protection Act, named after its sponsors, former Sen. Chris Dodd of Connecticut and Rep. Barney Frank of Massachusetts. Congress passed Dodd-Frank last year, pledging to curb industry excesses that led to a near meltdown of financial markets in 2007-08.

But even before Dodd-Frank took effect, a debate raged over whether another oddly named law, the Gramm-Leach-Bliley Act of 1999, contributed to the financial crisis by repealing banking safeguards erected during the Great Depression.

There is a Virginia angle in this debate. One of the sponsors of Gramm-Leach-Bliley was longtime Republican Rep. Tom Bliley of Richmond, while the late Democratic Sen. Carter Glass, a former Treasury secretary in the Wilson administration, was a patron of the 1933 banking law, the venerable Glass-Steagall Act.

Among other things, Glass-Steagall prevented bank holding companies from owning investment banks, following the theory that commercial banks needed to be insulated from the effects of stock market speculation.

Gramm-Leach-Bliley, signed into law by President Clinton in the boom times of the late 1990s, repealed this provision. At the Virginia-centric Richmond News Leader, where I worked before its demise in 1992, the headline might have read, “Bliley law cracks Glass Act.”
But some critics of Gramm-Leach-Bliley, including President Obama, believe it did more damage than that, blaming the law for the creation of giant financial companies that became “too big to fail.”

Two leading Virginia banking experts, however, don’t buy that argument.

“I do not believe that Gramm-Leach-Bliley contributed significantly to the recent crisis,” says J. Alfred Broaddus Jr., former president of the Federal Reserve Bank of Richmond. First of all, he doesn’t think that Glass-Steagall’s separation of commercial and investment banking was necessary. “There is little evidence that the combination of the two before Glass-Steagall contributed materially” to the Great Depression.

That realization, Broaddus, says, led eventually to the passage of Gramm-Leach-Bliley. The law allowed a holding company to own a commercial bank and an investment bank but did not permit these operations to be fully integrated. Commercial banking functions were still overseen by regulators such as the Comptroller of the Currency and the Federal Reserve, while investment banking was regulated by other agencies, primarily the Securities and Exchange Commission. 

Another banking expert, Neil B. Murphy, says Gramm-Leach-Bliley also was the result of Congress’ recognition that the separation of commercial and investment banks promised by Glass-Steagall, had already broken down piecemeal over the years. “This occurred due to a process of technological change, product innovation and regulatory actions that had given the large institutions much of what they were supposedly denied by Glass-Steagall,” says Murphy, professor emeritus at Virginia Commonwealth University School of Business and an adviser to the Banking and Financial Services Program in the Treasury Department’s Office of Technical Assistance.

Before Gramm-Leach-Bliley, he says, “the U.S. was out of synch with the rest of the developed financial world. This created some competitive problems for U.S. financial firms in a global context.”

Broaddus notes that few investment and commercial banks actually took advantage of Gramm-Leach-Bliley to combine. The biggest problems in the latest financial crisis, in fact, were posed by the failures of investment banks Lehman Brothers and Bear Stearns, neither of which were owned by commercial bank holding companies. “So it’s hard for me to understand how the mere allowance of investment bank-commercial bank combinations in holding companies by Gramm-Leach-Bliley contributed much to the crisis,” he says.

The real problem, Broaddus believes, was weak regulation of investment banks.  “The SEC, in particular, never had the resources or the mandate to regulate the investment banks as rigorously as the bank regulators regulated the banks, even taking account of the evident shortcomings of the bank regulators before the crisis,” he says.  “In sum, it seems to me that if the investment banks that got into such big trouble had been more fully integrated with commercial banks in the period leading up to the crisis, and —  most importantly —  had been subject to bank-like regulation by bank regulators, I think the crisis might have been avoided and would almost certainly have been moderated.”

So if Glass-Steagall didn’t cure the causes of the Great Depression and Gramm-Leach-Bliley didn’t provoke or prevent the financial crisis in 2007-08, what hope should we have for Dodd-Frank?

“While there’s much to criticize in Dodd-Frank, its extension of the Fed’s overall financial stability mandate to cover the major investment banks makes sense in my view,” says Broaddus.

“I think that the most important part of Dodd-Frank is the resolution authority [for liquidating failed financial institutions],” Murphy says. “For market discipline to work, creditors must believe that they are really at risk.  Let’s hope that the new regime ends the possibility of games of financial ‘chicken’ in which large financial firms confront the authorities with the stark choice of financial chaos or a ‘bailout.’”
Otherwise Congress once again will be fighting the last war on the financial front. 

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