A New Glass-Steagall?
Jazz, barbecue, and now Kansas City has also its own distinctive style of financial reform, put forward in a recent paper by Hoenig and Morris, respectively President and Vice President of the Kansas City Fed. Whereas the 1933 Glass-Steagall Act drew a sharp line between investment banking and commercial banking, Hoenig and Morris propose to draw a similarly sharp line between complex/risky banking and comprehensible/core banking. Only the latter institutions would continue to benefit from the public safety net, and also be subject to public regulation and supervision.
The proposal comes at an opportune moment, as authorities are considering the specifics of the new post-crisis regulatory regime, which increasingly seem to be falling short of any fundamental reform (see here, and here, for example).
The proposal emerges from a distinctive account of the origin of the crisis, which the authors see through the lens of traditional commercial banking, not to say Jimmy Stewart banking, or safe and sound banking. Starting in 1971, the deposit taking side of that traditional business suffered erosion from money market mutual funds, while the lending side suffered continuing erosion from finance companies and other market-based sources of funding. The end result of decades of financial innovation was a parallel or shadow banking system that provided all the core banking services but without the regulatory burden of the traditional banking system, and also without explicit access to the public safety net.
Because it was outside the regulatory structure, the shadow banking system blurred the sharp edges of Glass-Steagall, with the result that core banking activities got intertwined with complex and risky activities, specifically securities dealing and market making, brokerage, and proprietary trading. “The financial system has become less stable over the past 30 years as banks and other financial companies have expanded into more complicated activities that are not supported by a public safety net or subject to prudential supervision.”
The road forward, in this view, is once again to separate essential core banking from inessential complex banking, just as we did in 1933. This time, however, the authors propose to include underwriting and advisory services, as well as asset and wealth management services, among the essential core functions. The sharp line of division is not between investment banking and commercial banking, but between inessential complex activities and essential core activities. The explicit rationale is to control the risk exposure of the public safety net; the implicit rationale is to support the franchise of traditional commercial banking.
To their credit, the authors appreciate that a new Glass-Steagall will be subject to much the same erosion by regulatory arbitrage as was the old Glass-Steagall. Specifically, they worry that their proposal will offer incentive for rebuilding the shadow banking system, and to make sure that does not happen they propose two additional measures. Their strategy is essentially to cut off the funding of the shadow banking system.
In their proposal, money market mutual funds would no longer be allowed to offer accounts that fix net asset value at $1 (and so offer close substitutes for commercial bank deposit accounts), but rather would be required to have floating NAV like other mutual funds. This would presumably make such accounts unattractive to corporate treasurers, and restore the deposit funding of commercial banks.
Second, repo would no longer be exempt from the automatic stay in bankruptcy, which would make repo lending less attractive relative to commercial bank deposits, even though repo is secured.
In short and in sum, the Kansas City vision for the future of finance involves a substantially enlarged and revitalized traditional commercial banking sector. The whole point is to split the shadow banking system into essential and inessential activities, and to shift the essential ones into the commercial banking sector while letting the inessential ones, shorn of their connection to the public safety net, wither away.
I choose these words carefully, in order to bring into the foreground the underlying assumption of the whole proposal, namely the inessential character of the forbidden activities, specifically securities dealing and market making, brokerage, and proprietary trading. In the Kansas City version of the history, the rise of shadow banking is entirely about regulatory arbitrage; the shift in the last thirty years from a bank loan-centered credit system to a capital market-centered credit system is simply a mistake that we now have the opportunity to correct.
Maybe so, but maybe also there are other reasons for the shift to a market-centered credit system. The important point is that, to the extent the market-centered credit system is here to stay, the institutions that support the liquidity of that market system are also here to stay. Even more, to that extent we should view those institutions as essential to the operation of our credit system. The problem is not, as KC would have it, how to keep those institutions out of the safety net but rather how to bring them in explicitly, along with a reformed system of regulation and supervision that ensures their safety and soundness. That problem has been, and will remain, a central concern of the Money View blog.