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Banking regulation.

* "The Gramm-Leach-Bliley Act of 1999: A Bridge Too Far? Or Not Far Enough?" by Lawrence J. White. May 2011. SSRN #1836668.

* "Robust Capital Regulation;' by Viral Acharya, Hamid Mehran, Til Schuermann, and Anjan Thakor. April 2011. SSRN #1822333.

Many commentators, including former Federal Reserve Board chairman Paul Volcker, have blamed the recent financial crisis and subsequent recession on the 1999 Gramm Leach-Bliley Act (GLB), which eliminated the legal barriers between investment (securities) and commercial (traditional deposits and loans) banking and insurance. In a recent paper, New York University economist Lawrence White argues that this blame is misplaced for two reasons.

First, the Depression-era theory that investment and commercial banking should be separated has long been discredited by academic economists. The theory alleges that the stock market crash of 1929 was the result of investment banks selling poor-quality stocks to an uninformed public in order to help the stock-issuing companies repay loans from the investment banks' affiliated commercial banks. Randall Kroszner and Raghuram Rajan ("Is the Glass-Steagall Act Justified," American Economic Review, Vol. 84, No. 4) debunked this theory nearly two decades ago when they showed that securities underwritten by banks with affiliates were no more likely to default than similar securities issued by independent investment banks during 1924-1940.

Second, GLB simply granted congressional recognition of regulatory decisions in the 1970s and 1980s that blurred the distinctions between investment and commercial banking. Those decisions had been incorporated into the marketplace long before 1999, as evidenced by the creation of money market funds, the securitization of mortgages, and the direct access of corporations to loans through the commercial paper market.

For White, the financial crisis was the result of high-leveraged lending to the housing sector, and those loans ultimately went sour with the 2006-2007 popping of the real estate bubble. What's relevant to the GLB discussion is that those losses did not occur because commercial banks underwrote corporate securities, or traded for their own account, or operated hedge funds. The losses occurred because both commercial and investment banks invested in mortgage-related bonds, which was legal (and encouraged) long before GLB. Hence, White concludes, the reimposition of Glass-Steagall Act rules separating investment banking from commercial banking would "not even be a case of locking the barn door after the horses have run out. Instead, it would be a case of closing a set of side doors that the horses hardly notice."

This is not to say that GLB doesn't deserve some criticism relevant to the financial crisis. GLB increased the barriers between commerce and banking, which hurt low-income consumers. In the late 1990s, Wal-Mart wanted to enter retail banking, both in an effort to lower its credit card costs and because it saw a profit opportunity. Existing banks, existing retailers, labor unions, and other opponents of Wal-Mart succeeded in inserting language into GLB that prevented any acquisition of a unitary thrift holding company by a commercial or industrial company, thereby blocking Wal-Mart's plans. Low-income consumers would be better served by aggressive entry by companies like Wal-Mart with a proven track record of serving low-income customers-indeed, they'd benefit far more from this than programs like the Community Reinvestment Act that "pressure" existing banks to lend to the poor.

Another recent paper, by Viral Acharya et al., examines the role that high-leveraged lending played in the financial crisis. It is now consensus that high-leverage financing--that is, extensive borrowing by banks, which then used the borrowed money to finance housing and other investments--fueled the housing bubble. Many policy analysts reason that decreased leverage--that is, increased use by banks of their shareholders' money to finance such investing, instead of borrowing--would allow the banks to survive large asset losses and decrease the need for future government bailouts.

The authors of this paper worry that such a change could ultimately lead to more financial problems. Snakebit uninsured large depositors and debt--holders now have powerful incentive to monitor the investment behavior of financial institutions that want to borrow (or have already borrowed) their money; a switch to greater equity financing would dampen that vigilance.

Acharya et al. propose that financial firms be required to have a "mandatory equity buffer"--in effect, a firm "rainy day fund"--funded out of retained earnings. This would insure savings during good times and use of the savings during bad. The equity buffer would be transferred to the normal capital account of the financial institution automatically when prearranged capital levels are breached because of loan losses. If the bank becomes insolvent, the equity buffer would revert to the Federal Deposit Insurance Corporation so that uninsured debt-holders would not benefit directly from the extra equity and thus still have incentive to monitor the bank's loans.

The objection to increased capital requirements is that they would reduce the value of banks. Acharya et al. respond by invoking the insights from a paper by Anat Admati that I described in an earlier Workings Papers column (Winter 2010-2011). Equity is "expensive" only because banks are so highly leveraged and thus risky. More equity reduces risk and thus reduces the "cost" of the equity. The result is that more equity does not reduce the market value of banks.

Peter Van Doren is editor of Regulation and senior fellow at the Cato Institute.
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Author:Van Doren, Peter
Article Type:Legislation
Geographic Code:1USA
Date:Jun 22, 2012
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