Ifo Viewpoint No. 112: A new Glass-Steagall Act?

Hans-Werner Sinn
Munich, 09. February 2010

The hurricane of the financial crisis has been withstood but has left behind a swath of destrucction in the United States. The US devoted 1.3 trillion dollars to rescue the banks and 800 billion dollars for economic stimulus packages. Private real-estate financing has completely collapsed 95 percent of loans for private real-estate in 2009 was channelled through government institutions. More than 200 banks went bankrupt during the crisis. The GDP/debt ratio in the US will approach the 100-percent mark this year and exceed it probably in 2011 or early 2012.

Now that the storm has subsided it is time to clear away the debris from the shattered financial system. After initial hesitation, US president Barack Obama now seems ready to take action and is supporting the proposals of former Fed chairman Paul Volcker.

Volcker has proposed reactivating the American system of separate investment and commercial banks that was created by the Glass-Steagall Act. The act was established in 1933, shortly after the worst phase of the Great Depression, and it forbade commercial banks from acting as investment banks. The commercial banks were allowed to lend deposited savings to private households, businesses and other banks, but they were not allowed to buy securities or to assist in their exchange. The purchase of stocks was forbidden as was the acquisition of securitised financial products. Even the purchase of corporate bonds and private debentures was limited to a negligible minimum. The goal of the legislation was to protect savers from risky financial transactions.

When the Glass-Steagall Act was repealed in 1999, some commercial banks made hesitant attempts at investment banking, which gave rise to suspicions that this could have been a reason for the financial crisis. But this is far from the truth since in reality the system of bank separation remained fairly intact up to the outbreak of the crisis.

As is well-known, the crisis was triggered in 2008 by the unexpected failure of the government to rescue Lehman Brothers. That destroyed banks’ trust in each other and froze up the interbank market. Deposited savings could no longer be channelled to investors but backed up at the commercial banks. The result was a crash of the real economy. If the US had not had a separation of banks, the economy would have been less susceptible to a breakdown of the interbank market, since the commercial banks could have routed at least part of deposited savings to businesses via the purchase of stocks or bonds.

With this in mind we may wonder what motivated Obama and Volcker. The answer lies in an event on 22 September 2008 that took the financial world by surprise: the conversion of Goldman Sachs and Morgan Stanley, the last surviving large investment banks, into normal commercial banks. Behind this conversion was the desire of the two banks to attain access to cheap credit from the Fed and the protection of Federal Deposit Insurance Corporation (FDIC). The government actually wanted to exclude the investment banks from receiving special help, but they got around this by quickly changing their legal status. Now Obama is trying to square up accounts.

This is understandable but dangerous for Europe because Europe has a universal banking system. If Obama succeeds in anchoring a separation of commercial and investment banks worldwide at the G20 negotiations, this would mean a destruction of the European banking world, whereas in the US the repercussions of the reform would be limited. Hopefully Obama’s advisers were not inspired by this prospect.

Crisis prevention will certainly not come from a return to a system of bank separation. It is true that the reduced likelihood of government help will induce investment banks to act more cautiously. But this plus point does not offset the increased susceptibility to crisis from the division of banking functions. Moreover, it is doubtful whether the likelihood of government rescue will really be reduced. The state will have to rescue large investment banks even if they do not manage customer savings since no one would accept the repetition of another Lehman Brothers disaster.

The banks’ cavalier risk-taking that led to the crisis was basically due to their inadequate capital reserves. People are tempted to gamble if their own capital is hardly involved, because they can pocket the gains and only have to shoulder a small portion of the losses themselves, regardless of whether the state helps or not. The incentive to gamble can only be suppressed by drastically increasing capital reserve requirements.

The Europeans should not follow the American proposals at the next G20 summit but should concentrate fully and entirely on strengthening the capital reserves of the banks.

Hans-Werner Sinn
Professor for Economics and Public Finance
President of the Ifo Institute

Published as "Keine gute Idee", Wirtschaftswoche, No. 6, 8 February 2010, p. 38.