Making Banks Boring

Bloomberg has an editorial arguing that making banks boring won't prevent a crisis; only increasing bank capital will do so.  

To the extent that its big point is that banks will suffer during an economic downturn and the only protection against that is more capital (or insurance, including from the government), it's hard to disagree.  But what this editorial misses is that 2008 wasn't just some periodic economic downturn that occured for reasons beyond our comprehension or control, like El Niño and La Niña weather patterns.  Instead, the 2008 financial crisis was made by the banks themselves. The 2008 financial crisis was the inevitable result of the financial services' industry's behavior in the 2000s.  And that's why we have to make banking boring. Boring banks might be hurt by economic crises, but they don't make them. We cannot prevent every economic downturn, but there's no reason we should suffer the preventable ones.  

So how is boring banking a solution? It matters for two reasons, one widely understood, and the second entirely overlooked.  

First, boring banking does a reasonably good job of aligning risks and rewards for the parties actually making loans, and this helps control against asset price bubble. Boring banking, in its simplest, most stripped down form means that banks make loans and hold them on their balance sheets. (There are problems that can stem from this, namely from the asset-liability duration mismatch, but that's another issue, and the other banking crises cited by Bloomberg didn't pose systemic threats like 2008.) 

The primary reason that the banks ran into trouble in 2008 was not because they were making bad loans that they held on portfolio. Instead, they made bad loans because they knew those loans would be securitized. The problem was that the banks then went and bought into those very same securitizations, which they then used as collateral for their short-term borrowings (such as repo), making them intensely exposed to the performance of their MBS. 

The overprovision of underpriced credit enabled borrowers to bid up asset prices, which then meant that subsequent loans looked better than they were in terms of LTV.  Once lax securitization practices ignited the bubble, it affected not only securitized loans, but also balance sheet loans. And then it was pretty much inevitable that someone would get spooked as evidence of poor loan performance speed in and a run and then a market-freezing panic would result that would hit all uninsured short-term credit as no one could be sure which institutions were impaired and which were money good.  The fact that the banks were heavily leveraged didn't help things, and Bloomberg is right that more capital would have softened the blow. But better to avoid the problems in the first place than to hope that capital will be sufficient.  

The second reason for making banking boring is one that is continually overlooked in the New Glass-Steagal debate, namely the political benefit of separating commercial from investment banking, which helps ensure against deregulation. Commercial and investment banks can both get into trouble when they're not regulated. Indeed, the stories of the S&L crisis and of 2008 are fundamentally stories about deregulation.  Glass-Steagal made commercial banking boring by divorcing it from securities. Glass-Steagal also split the financial services industry politically and enabled the different parts of the industry to be played against each other. Commercial banks, investment banks, and insurance companies fought each other for turf for decades. This mattered in terms of regulation because regulation is a political game.

Because of Glass-Steagal, the financial services industry did not present a monolith in terms of lobbying, and a Congressman could afford to take a stand against one part of the industry because there would be campaign contributions forthcoming from the other parts of the industry. This is how William O. Douglas got the Trust Indenture Act of 1939 passed--he made concessions to the commercial banks in order to get their support for legislation that kept the investment banks out of the indenture trustee business. In the agencies, each part of the industry had its pet group of regulators who would push back against other regulators when they thought that there was an encroachment on their turf, which is the basic nature of deregulation---allowing greater activities than previously allowed. And it even mattered in the courts, as the insurance and investment banking industries financed major litigation challenges to commercial bank deregulation. The result of a politically fragmented financial services industry was to hold deregulation at bay for quite a while. This started to unwind in the 1980s and by the Gramm-Leach-Bliley Act, it was over. It didn't take long before we all reaped the fruits of deregulation.

If you want to see more modern examples of the benefits of divided industries, see the FDA's recent decision on the naming of high fructose corn syrup. It's going to keep going by that name, rather than by "corn sugar" because in part from intense lobbying pushback from another part of the sweetener industry--the cane and beet sugar manufacturers. Sarbanes-Oxley passed in part because of a split between the Business Roundtable and the US Chamber of Commerce. And in the financial institutions space, the Durbin Interchange Amendment passed because it posed banks against another heavy duty group, retailers. 

In short, yes, we need more capital and/or insurance as a cushion for banks during downturns. But we also need to make sure that the banks are not fueling the behavior that leads to economic crashes and downturns. That means in part ensuring that there is adequate regulation of the financial sector, and that requires breaking the political power of the banks. Glass-Steagal accomplishes a political breakup of the banks; neither the Volcker Rule nor capital requirements do. That's why we need to make banking boring.