Sunday, April 8, 2012

Thomas Cooley has the floor

Dean of the NYU Stern School of Business has weighed in before:
It wasn’t a burst of free-market fundamentalism that motivated the removal of Glass-Steagall’s restrictions. By the time the Graham-Leach-Bliley Act passed in 1999, the regulatory architecture of the 1930s was long since dead, killed not by a set of beliefs about the markets’ ability to discipline themselves but by innovation.

Innovation occurred for many reasons: the end of the Bretton Woods system of fixed exchange rates created a need for currency hedging instruments and swap arrangements; high inflation rates inspired the development of certificates of deposit and NOW accounts; and regulatory arbitrage. New business models made it possible to evade the constraints of regulation.
Also, from Cooley back in 2009;
Given enough transparency, investors were capable of making smart and profitable long-term decisions. These [New Deal era banking regulations] were intelligent, effective pro-market regulations that worked well for many decades. Until they didn't.

What happened? The short answer is innovation. Technological change combined with the desire of investors to earn greater returns rendered many of the restrictions of Glass-Steagall obsolete. In the 1970s, as inflation rose to high levels, the penalty for keeping funds in deposit accounts that had no or little return became very high. At the same time, technological change made it possible to sweep money in and out of banks at high frequency and thus offer greater returns for depositors. Market participants bridled at the restrictions that were holding back innovation.

Negotiable Order of Withdrawl, or NOW, accounts, technically not checking accounts, began to attract deposits. Merrill Lynch (nyse: MER - news - people ), a brokerage house, created the Cash Management Account and patented the idea in 1982. Bank customers could keep stocks, bonds and other securities in one umbrella account. They could write checks against their assets and receive money-market rates on free cash balances.

Commercial banks were unhappy about this competition, but once the barrier was breached, investment banks and commercial banks were competing head-to-head for customers and yield. So long, Glass-Steagall. Almost indistinguishable now, banks and investment houses expanded their lines of business and grew into financial supermarkets organized under bank holding companies.

Regulation lagged far behind innovation and became purely reactive. The SEC had to adapt to the increasing complexity created by financial innovation and struggled to keep up. Most important, it was somehow unable to recognize that innovation in the industry, while immensely profitable, also created new kinds of risk.

By the time the Gramm-Leach-Bliley Act was passed in 1999, repealing most of the provisions of the Glass-Steagall Act, legislators were simply endorsing what had already happened in the industry. These were trends that in some sense were actively encouraged by the SEC, other regulators and the regulated themselves as friendly to innovation and efficiency in financial markets.
Unfortunately, Mr Cooley makes a small error in the above; 'repealing most of the provisions of the Glass-Steagall Act' should be 'repealing TWO of the provisions'. Those two provisions changed the rules of affiliations between banks and investment firms, not the separation of such firms. That provision (#16) is still in effect. FDIC insured checking deposits cannot be used to underwrite corporate securities to this day.

Otherwise Mr. Cooley is correct, technology made some of Glass-Steagall irrelevant and Gramm, Leach, Blilely was something of a johnny-come-lately to the party.

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