Best of the Week
Most Popular
1. TESLA! Cathy Wood ARK Funds Bubble BURSTS! - 12th May 21
2.Stock Market Entering Early Summer Correction Trend Forecast - 10th May 21
3.GOLD GDX, HUI Stocks - Will Paradise Turn into a Dystopia? - 11th May 21
4.Crypto Bubble Bursts! Nicehash Suspends Coinbase Withdrawals, Bitcoin, Ethereum Bear Market Begins - 16th May 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.Cathy Wood Ark Invest Funds Bubble BURSTS! ARKK, ARKG, Tesla Entering Severe Bear Market - 13th May 21
7.Stock Market - Should You Be In Cash Right Now? - 17th May 21
8.Gold to Benefit from Mounting US Debt Pile - 14th May 21
9.Coronavius Covid-19 in Italy in August 2019! - 13th May 21
10.How to Invest in HIGH RISK Tech Stocks for 2021 and Beyond - Part 2 of 2 - 18th May 21
Last 7 days
Junior Gold Miners: New Yearly Lows! Will We See a Further Drop? - 23rd Jul 21
Best Forex Strategy for Consistent Profits - 23rd Jul 21
Popular Forex Brokers That You Might Want to Check Out - 22nd Jul 21
Bitcoin Black Swan - Will Crypto Currencies Get Banned? - 22nd Jul 21
Bitcoin Price Enters Stage #4 Excess Phase Peak Breakdown – Where To Next? - 22nd Jul 21
Powell Gave Congress Dovish Signs. Will It Help Gold Price? - 22nd Jul 21
What’s Next For Gold Is Always About The US Dollar - 22nd Jul 21
URGENT! ALL Windows 10 Users Must Do this NOW! Windows Image Backup Before it is Too Late! - 22nd Jul 21
Bitcoin Price CRASH, How to SELL BTC at $40k! Real Analysis vs Shill Coin Pumper's and Clueless Newbs - 21st Jul 21
Emotional Stock Traders React To Recent Market Rotation – Are You Ready For What’s Next? - 21st Jul 21
Killing Driveway Weeds FAST with a Pressure Washer - 8 months Later - Did it work?- Block Paving Weeds - 21st Jul 21
Post-Covid Stimulus Payouts & The US Fed Push Global Investors Deeper Into US Value Bubble - 21st Jul 21
What is Social Trading - 21st Jul 21
Would Transparency Help Crypto? - 21st Jul 21
AI Predicts US Tech Stocks Price Valuations Three Years Ahead (ASVF) - 20th Jul 21
Gold Asks: Has Inflation Already Peaked? - 20th Jul 21
FREE PASS to Analysis and Trend forecasts of 50+ Global Markets by Elliott Wave International - 20th Jul 21
Nissan to Create 1000s of jobs with electric vehicle investment in UK - 20th Jul 21
Bitcoin Halvings Price Forecast and Stock to Flow Analysis - 18th Jul 21
Dell S3220DGF Unboxing and Stand Assembly - 32 Inch 165hz Curved Gaming Monitor Amazon Discount - 18th Jul 21
What Does The Fed Mean By “Transitory Inflation” And Why Is It Important To Understand? - 18th Jul 21
Will the US stock market’s worsening breadth matter? - 18th Jul 21
Bitcoin Halving's Price Projection Forecasts Trend Trajectory - 18th Jul 21
Dell S3220DGF Price CRASH to £305! 32 Inch 165hz Curved Gaming Monitor Amazon Bargain - 16th Jul 21
Google, Amazon and Netflix are Scrambling For This Rare Gas - 16th Jul 21
Sheffield Millhouses Park New Children's Play Area July 2021 Vs Old Play Area - Better or Worse? - 16th Jul 21
Inflation Soars, Powell Remains Unmoved. What about Gold? - 16th Jul 21
Goldrunner: Gold Could Jump To $1,900-$2,100 In Next 30 days – Here’s Why - 15th Jul 21
Tips For Finding The Right Influencers - 15th Jul 21
ECB Changed Monetary Strategy. Will It Alter Gold’s Course? - 15th Jul 21
NASA And Big Tech Are Facing Off Over This Rare Gas - 15th Jul 21
Will the U.S. Dollar Lose Momentum In the Second Half of 2021? - 15th Jul 21
Bitcoin Stock to Flow Model Forecasts Infinity and Beyond! - 14th Jul 21
Proteomics: The Next Truly Massive Investing Opportunity - 14th Jul 21
Massive Solar Storm to Hit Earth 2025, Coronal Mass Ejection (CME) Danger and Protection Solutions - 14th Jul 21
Is This The Best Way To Play The Coming Helium Boom? - 14th Jul 21
Meet SuperMania and its Ever-Present Sidekick, SuperMeltdown - 14th Jul 21
How NFTs Are Shaking Up Arts Trading - 14th Jul 21
Gold: High Time to Move Out of the Penthouse - 13th Jul 21
Climb Aboard! Silver Should Run Up To $38 In Next 30 Days - 13th Jul 21
How Will Remote Work Impact the U.K. economy? - 13th Jul 21
Why Helium Stocks Are Set To Soar in 2021 - 13th Jul 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Fallacies of Pearlstein's WaPo op-ed on Glass-Steagall

Politics / Credit Crisis 2012 Aug 06, 2012 - 09:06 AM GMT

By: ECB_Watch

Politics

Best Financial Markets Analysis ArticleWhile not an expert on banking legislation, I've come across sufficiently visible fallacies in rejecting the notion that the repeal of Glass-Steagall was a factor of crisis, I felt confident enough to write a post describing them (jump to 'Also see'). The Washington Post now publishes an article by Steven Pearlstein repeating the same fallacies: 'Let's shatter the myth on Glass Steagall' (WP). Both Sorkin and Pearlstein are recipient of prestigious awards (Gerald Loeb and Pulitzer).


Misguided reasoning

The method of Sorkin and Pearlstein is to look at specific institutions—Lehman, JP Morgan etc.—that either failed or didn't and reason that Glass-Steagall wouldn't have helped or was unnecessary. For example:

The infamous AIG? An insurance firm. New Century Financial? A real estate investment trust. No Glass-Steagall there—Pearlstein
This exercise is futile because the nature of a system is not revealed by studying its local components. Pearlstein's other approach is to point to alternate phenomena, macro imbalances, the development of shadow banking, consolidation, complexity etc. as more probable causes of the crisis. This also misses the point and they both rely in many cases on distorted facts or half truths.

The activities of banking, no matter how complex, essentially boil down to borrowing and lending and payment transfers. Think of institutions as nodes in a network in which transactions between them form the connections. Such a system is too complex to forecast or control. The idea of Glass-Steagall is to carve out a sub-network—call it commercial banking, constrain its complexity, and keep its dependency to the the rest of the network—call it investment banking—low. In doing so, the sub-network is supposed to become more robust and behave in a more predictable way than the fusion of commercial and investment banking, a.k.a one-stop-shop-banking or (in Europe) universal banking.

Public utility

If your town is evacuated to flee a disaster, you bring with you what is most essential to your livelihood during and in the aftermath of the crisis, knowing the disaster could destroy what you leave behind. It's the same principle with Glass-Steagall. One puts in commercial banking, in terms of type of activities and group of clients, only what is most essential for the survival of the system, put safeguards around it and vouch to rescue it if necessary. Being able to use your credit card and cashing your salary check come at the top of the list of activities to protect.

Take this paragraph from Pearlstein:
The evidence is now overwhelming that top executives and directors and regulators are often clueless about risks deliberately taken and corners knowingly cut by people working under their direction. The chances of that happening grow with the size and complexity of the bank.

Everyone knows this, but it's not a good reason dismiss Glass-Steagall. Provided it does indeed mitigate the contagion of risk from investment banking to commercial banking, it takes away  from the former the implicit government guarantee that currently exists and whose exercise has unfortunately defined the crisis response (TARP). This guarantee, in the current system, creates an incentive for banks to take more risk that they can bear. Why do you think bank executives hire lobbies to preserve the statu quo other than for safeguarding this privilege for themselves?

To summarize, Glass-Steagall acts a public utility in that it safeguards essential infracstructure, but, at the same time suppresses Moral hazard. Targeted, rather than omnipresent, regulation.

Lehman straw man

In application of the enunciated principles, saying that Lehman, while an investment bank, had to be rescued, is a straw man. The relevant questions are: a) would the likelihood of a Lehman moment have been the same under G/S and, b) if it strikes, what the implications would have been for pure commercial banks? The answer to a) is no, because there would have been less moral hazard (see above).

When the government guarantee is strictly confined to commercial banking, the incentive for greater risk within is offset by strict (by requirement) and enforceable (thanks to reduced complexity)  regulation. That includes limits on wholesale funding which is the first channel of contagion in a liquidity crisis as exemplified in the fall of Lehman. The answer to b), therefore, is 'lesser implications'.

In the abstract, the argument for Glass-Steagall is strong: regulate the segment of banking that is most critical for day to day business as a utility and protect it as such. The devil, of course, is in the detail of the implementation. Sorkin and Pearlstein should have focused their attention on that.

Detail, however, is not more their forte than method. Pearlstein says that 'Wachovia and Washington Mutual, got into trouble the old-fashioned way – largely by making risky loans to homeowners'. They equate Glass-Steagall with separation of commercial and investment banking, an aspect that was repealed in 1999. However, under the original legislation, they couldn't have packaged the loans into securities they then sold. The 1984 SMMEA made that possible.

Glass-Steagall was dismantled and negated by a series of legislative acts. Sorkin and Pearlstein haven't carefully studied the legislative history surrounding Glass-Steagall. They just throw dirt at the wall hoping some will stick.

Half truths and distorted facts

According to Pearlstein, JP Morgan could have weathered the crisis without TARP. That's what Dimon would have us believe. Besides, JP M allegedly eased its way through the crisis by manipulating LIBOR, which is equivalent to a fraudulent subsidy. No mention of that is deceit. Even if JP M was forced to take the money, that's because the giving party thought it needed it. Why give Dimon precedence over the US Treasury? Citibank, which is also a one stop shop bank (and notoriously opaque at that), isn't cited, whereas it also received TARP money in the hundreds of Bns. Selective omission.

Pearlstein points to mass bank failures that occurred prior to the repeal of Glass-Steagall in 1999. The internet bubble and the GFC which occurred during 2000-2010 mark a significant increase in systemic risk. Whether one takes the view that the repeal was irrelevant or an aggravating factor, based on this, is a conjecture. Still, the empirical evidence favors the second hypothesis.

Sorkin and Pearlstein haven't risen to the challenge on this topic; they are complacent. Admittedly, it's a deep issue, and arguments from both sides need to be confronted much more rigorously.

Other

Both 'modularity'—as opposed to TBTF— and 'circuit breakers', such as separation of commercial and investment banking, are supported by a significant study in the global systemic collapse realized by a physicist (ZH).

Source http://ecb-watch.blogspot.co.uk/2012/07/glass-steagall-lets-shatter-myth-on.html

By Jareth

ECB Watch

© 2011 Copyright ECB Watch - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in