Thursday, April 19, 2012

Go ahead, make his day

Repeal Glass-Steagall (the Banking Act of 1933).  Really.  Not the piddling two sections that Gramm, Leach, Bliley touched in 1999--which left some 30 sections of it in place, but the entire thing, especially the FDIC and the idea of too big to fail.

According to Rutgers economist Eugene White in his paper comparing the real estate bubble of the 1920s to that of the 1993-2007 period, the existence of deposit insurance and the disposition to rescue over-leveraged institutions today is why the more recent crisis turned out to be more severe.

Even though the dimensions of the residential housing “bubbles” were similar, the bust in the twenties did not undermine the banking system or derail the economy.  Many of the alleged causes of the recent disaster were also in evidence in the 1920s.  There appears to have been an easing of monetary policy by the Federal Reserve, an equivalent “Greenspan put,” and unresponsive and perhaps facilitating bank supervision at the  federal and the state levels.  Bank lending standards declined and the high risk in the booming securitized mortgage industry was undetected by the rating agencies or the public because of the opaque nature of the securitized instruments.  All of these factors certainly contributed to the boom, but they were not enough to undermine the banking system.    
What was absent in the 1920s and what, by comparison, seems to have been central to today’s far greater disaster, were policies that induced banks to take increased the twenties, bankers  were not tempted by moral hazard from deposit insurance or the “Too Big to Fail” policy to take more risk on or off their balance sheets.  In fact, the general imposition of double liability on bank stock may have induced bank managers, subjected to greater monitoring by shareholders, to reduce risk-taking.  
According to White, prior to the Banking Act of 1933, investors had 'double liability'; they not only could lose all of what they had invested if the bank failed, but the bank's receivers could go after whatever other assets the investors had, to satisfy depositors and creditors, up to twice the amount of their original investment!

Also, most banking officers had to post bonds of between one and three years salary that would be forfeit if the bank failed.

Deposit insurance--which had been tried and found wanting in several states--created by 'Glass-Steagall' eliminated those incentives for bank shareholders to closely monitor their banks' performance.  And also apparently eliminated the practice of requiring bank managers to post bonds.

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