In the wake of the subprime mortgage crisis, Treasury Secretary Henry Paulson and Fed chief Ben Bernanke both say that we can expect new oversight and supervision of U.S. financial institutions. The specifics of any such regulatory overhaul will likely be shaped by the crosscurrents of bank lobbying, political posturing in a campaign year, and agency wrangles over turf.

But it’s a good bet that by this time next year we can expect a more uniform treatment of investment banks (think Bear Stearns, before it was dissolved) and commercial banks (think Bank of America).

Why? Once the Fed engineered the de facto Bear Stearns bailout (in the form of Bear’s sale to J.P. Morgan Chase) on the weekend before St. Patrick’s Day 2008, it crossed over into uncharted territory.  Before Saint Patrick’s Day weekend, in other words, the Fed was committed only to supporting commercial banks in their hour of need.

Why did the Fed choose to intervene to save a financial institution that seemingly could have failed with no risk to American taxpayers? The answer can be found in recently released Fed minutes. The Fed feared a Bear-Stearns bankruptcy would have set off a “contagion,” igniting a chain of contracts known as credit default swaps the system could not deliver on.  Credit default swaps can be thought of as endlessly intertwined insurance policies. The Fed evidently feared that one falling domino could trigger a series of defaults on such contracts and a cascade of bank failures in the U.S. and abroad.

A new rulebook is on the way.  Where should it start?  Not by overturning deregulation measures that allowed interstate branching, which increased competition and helped consumers—or those that ended state usury laws capping interest rates on loans. These reforms have worked fairly well.

Instead, what may need a new look is the 1999 repeal of the Glass-Steagall Act. Enacted in 1933 as a reaction to shady stock manipulation in the Roaring Twenties, Glass-Steagall mandated a separation of lending and deal-making.  The first function was to be handled by commercial banks, the second by investment banks—and never the twain should meet. As might be expected, by the mid-1980s, a half-century later, this separation hadbegun to fray at the edges.

By 1987, in a 3-2 vote, the Federal Reserve Board gave its sanction to ending the Glass-Steagall divide.  As it happened, one of the two dissenters was Paul Volcker, then Fed Chair. In his view, Glass-Steagall still served a useful function. (Indeed, after stepping down later that year, he would eventually be appointed to clean up the savings-and-loan mess of the late 1980s, itself a result in part of a botched  approach to deregulation.)

In 1999, after the urge-to-merge CEOs of Citibank and the Travelers Insurance company had personally lobbied President Clinton, Glass-Steagall was formally, once-and-for-all repealed. This opened the door to “full-service” or “smorgasbord” or “one-stop” universal banks. (For a timeline of this sequence see the 2003 PBS Frontline piece, “The Long Demise of Glass-Steagall,” at their website.)

The rationale? In the new banking environment at the Millennium, three safeguards would supposedly protect the public from the abuses that had led to the original act. (1) Under then chief Arthur Leavitt, the SEC had become a tiger with teeth, capable of patrolling the financial industry. (2) Investors (meaning largely institutional investors) had become highly sophisticated. (3) The bond-rating agencies could serve the public interest by evaluating and publicizing risks associated with corporate and (as it turned out!) mortgage-backed securities.  

In retrospect, of course, none of these three safeguards would insulate investors from the dot-com collapse of 2000—any more than they have prevented today’s subprime crisis.

However weak the three slender reeds now look, another problem with repeal was cited at the time by the Economist magazine, a bastion of free-market thinking since at least 1850. As the magazine pointed out in an editorial in its issue of October 30, 1999,

Why, if politicians are at last to do something about the Depression-era rules that govern financial firms, have they not tried to update America’s supervisory structure at the same time? It is hopelessly fragmented and costly. …History is liberally dotted with crises caused by liberalizing finance without improving supervision.

It appears that this missing link from 1999 is likely to re-surface in today’s search for new rules for banks.  In practice, post-Glass-Steagall banks have tended, in spite of some diversification, to retain their identities as primarily investment or primarily commercial banks.

If the Fed is going to bail out investment banks (not just commercial banks), then investment banks will probably be required to be as transparent and accountable as commercial banks.  On the accounting side, both will probably be required to show formerly hidden off-balance-sheet assets and liabilities on their balance sheets and to spell out their risk exposure more clearly than in the past.  

To that extent, the repeal of Glass-Steagall would now come full circle, and “universal” banks of whatever stripe would be subject to uniform rules.

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