National Economic Council Director Gary Cohn, formerly President of Goldman Sachs, startled markets last week by suggesting that the United States should re-impose the Glass-Steagall division between commercial and investment banking. That is probably desirable on balance, but the U.S. and global financial system was already a mess when Glass-Steagall was removed in 1999. We should do more, beyond restoring Glass-Steagall, to restore finance to its proper state.
The U.S. and British financial systems developed in different directions after 1870 or so. In Britain, the merchant banks were private partnerships, so were forced to stay small. Broking and dealing was hived off into specialist firms and the large deposit-taking banks never developed the IQ to become a serious threat to the merchants. The British financial system was thus stable, and could have remained so for millennia had it not been mutilated by successive governments through two world wars, decades of exchange control and a final decade of rampant inflation and crippling taxes.
In the United States, government policy was less damaging. However, the business mix of investment banking was different, the Trusts were much more interesting customers than the small and stagnant British industrial firms, while international business was only a modest part of the total mix. Consequently after 1900 major deposit-taking banks grew up that were not private partnerships and could grow to behemoth size. Naturally, since capital was not a constraint for such juggernauts, they took on trading businesses as well as commercial banking and true investment banking.
When 1929 happened, the British banking system was not much affected. The Bank of England prevented the merchant banks from making overseas loans, which had the mildly beneficial effect of forcing them to focus, fifty years late, on business from industrial companies. Then after three decades of somnolence they made a good job of recovering some of their international business in the 1960s. Unfortunately, among the other vital British interests Maynard Keynes gave away at the 1944 Bretton Woods conference was the emerging markets advisory business, for which he invented two unnecessary international institutions, the World Bank and the IMF, thereby providing the merchant banks with large-scale subsidized competition.
In the United States, the large banks with active trading desks proved as incompetent at managing their business in 1929 as they were to in 2008, resulting in two policy innovations by an aggrieved government: deposit insurance and the Glass-Steagall Act.
The arguments for and against deposit insurance are fairly finely balanced. On the one hand, you can’t expect little old ladies to examine bank balance sheets, especially when the banks are involved in areas like derivatives markets that obfuscate the balance sheet’s reality. On the other hand, deposit insurance, and the knowledge that their retail depositors don’t care whether they go bust or not, encourages banks to engage in excessive leverage.
Leverage in an industrial business is an iffy undertaking, leading to problems as often as not unless the business is in a very long bull market. However, in a bank leverage can be used to provide almost guaranteed profits (at least in the short term) simply by lending at higher interest rates than you borrow. The dangers of it are exemplified by a Chilean bank for which I once did a deal, which made excellent quality loans in pesos, funding them in dollars – and looked like a genius until the peso was devalued by 50% against the dollar. Even without such foolishness, leverage in banking is not a good thing, and deposit insurance removes a major restraint against it.
Even more dangerous than leverage in general, however, is leverage combined with the kinds of opaque off-balance-sheet derivatives deals that were so prevalent in the run-up to 2008, and have by no means disappeared since. Neither banks nor their regulators understand how to manage these risks, as evidenced by J.P. Morgan’s $9 billion loss in the “London whale” trades in the calm, mildly upbeat markets of 2012. The financial community was warned of the dangers of using Gaussian risk management models, for example, in Kevin Dowd’s and my “Alchemists of Loss” of 2010, yet still it uses them. The temptations through bonuses and stock options are so great that the fools who run banks just can’t stop themselves.
At the most basic level, therefore, Cohn is right. If we must have deposit insurance, it should not be combined with the massive trading operations and wild risk-taking characteristic of the Wall Street behemoths. However, Glass-Steagall itself does not do the necessary job; it separates securities underwriting from commercial banking, but continues to allow commercial banks to undertake the trading operations, in long-term derivatives, credit default swaps and other instruments, that form the true nexus of modern banking risk.
There is an additional subtler problem with the modern financial system. Advisory work, on mergers, financings and other matters, is the most crucial sector of investment banking. In the mergers area for example, large companies have consistently shown they are incapable of managing acquisition strategy on their own; top management is far too keen on empire building.
This can be seen in the sorry history of Kraft/Mondelez, where Kraft took over the admirable British confectioner Cadbury, then reneged on the promises it had made at the time of the acquisition, then split itself into two, spinning off the confectionary business Mondelez, then merged with Heinz, then made an unsuccessful bid for Unilever, and now there is talk that Kraft and Mondelez may merge again.
At each stage in this saga of futility, the management involved and its investment bankers paid themselves vast fees and bonuses. Apart from the fees, the motivation for the chain of transactions, all completed in much less than a decade, can only be that management was utterly bored with its portfolio of bog-standard, very mature consumer products businesses and had to do something to liven up its day and make a quick buck.
There needs to be some discipline on the process, applied by outsiders who can take a rational look at a business’s needs and possibilities, with knowledge of the m&a market and of successful strategies pursued by other firms. The outside advisor needs to be able to apply pressure where necessary, to ensure that management’s more foolish fantasies are stillborn. In Britain, this advisory role was traditionally played by the larger merchant banks, in the United States it was traditionally played by J.P. Morgan, but has been absent since 1929 as the post-Glass-Steagall investment banks were mere brokers, shilling for deals.
The best advisors tend to be in medium sized houses, which have fewer conflicts of interest with clients than today’s behemoths, with their bloated trading books. Hence an ideal financial system would have three parts:
• Commercial banks, whose deposits would be guaranteed. These would undertake lending business, and would be prohibited from the underwriting business, or from large trading positions, beyond simple foreign exchange and commercial paper with less than 1 year maturity. They would also be forbidden to deal in credit default swaps, except to hedge existing positions (if this killed the CDS market, so be it!)
• Investment banks, which would be medium sized institutions, probably set up by law as partnerships with no public listing. They would arrange financings (for which they would get underwriting commitments from institutional investors, as used to be done in London) and advise on mergers. They would have an additional business, descended from 19th Century merchant banks, of advising emerging market countries on their financing – the IMF and World Bank both need to vanish.) Investment banks would also undertake asset management for conservative and sensible investors, and probably a modicum of private equity business.
• Hedge funds, which would undertake most of the market’s trading activities and would be guaranteed by nobody. These fly-by-night institutions would wink in and out of existence rapidly, but would potentially make some pretty unpleasant people very rich, as they do today. They would provide most of the liquidity required by the market, but would have little contact with either industrial companies or the public (except the foolish and greedy members of the public who invested with them.)
All we would need then is a Fed that was suitably “Volckerized,” keeping real interest rates substantially positive in almost all circumstances, and you would have the makings of a sound financial system, in which all the bankruptcies would be concentrated in the hedge funds, whose investors and executives would deserve what they got.
If Cohn succeeds in returning us to a world of Glass-Steagall, that is at least a step in the right direction. However, it will achieve little while commercial banks are able to gamble with our money and the Fed is grossly over-indulgent with monetary policy. The latter problem could be solved with a swift yet carefully chosen replacement of Janet Yellen. However, we always knew that by electing a real estate billionaire, we would probably ensure that the Fed problem remained unsolved on President Trump’s watch.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)