By: Sofya Abdurakhmanova
To address the Great Depression, Congress passed significant legislation, which helped stabilize the rapidly failing banks at a time when they were falling like a set of dominos. Several banks closed, others reevaluated their balance sheets, and President Roosevelt pushed for passage of the Glass-Steagall Act and creation of regulatory agencies. Three years ago, banks once again started faltering. A run on Washington Mutual was an eerie reminder for many economists. The banks and investment groups were found to be “too big to fail” and the U.S., along with nations across the world, was left in the compromising position of buttressing these institutions while facing the problem of the moral hazard. The U.K., however, had a purported solution. The Independent Commission on Banking (ICB), a group formed by the coalition government to study and recommend reforms of the banking system, came out with a radical proposal: retail and small-business banks would be separated from the larger investment banks in a ring-fence model.
According to the proposal, the retail side, dealing with consumers and small businesses, would be ringed off and governed by a separate subsidiary of the larger bank. It would receive government protection and would be required to hold a significant reserve – equity of 10% and an additional 7-10% of loss-absorbing capital. However, retail banks would be forbidden from participating in riskier ventures like betting on markets using derivatives. Investment banks would not have to raise such a thick buffer of capital but they would no longer be in the “too big to fail” category, saving the U.K. from shelling out another $85 billion to a single bank. The current British government has indicated that the ICB recommendations will be adopted in full before the next general election in 2015 and will be implemented by 2019.
For the U.S., the proposal is nothing new but rather similar to the division provided in the Glass-Steagall Act. According to the Act, commercial banks were forbidden from underwriting and combining with investment banks. The separation was in effect since the time of Roosevelt until 1999 – though the barrier had been become permeable long before its repeal. However, the repeal, or the “modernization” of Glass-Steagall allowed mergers like Travelers-Citicorp and producing conglomerates in the financial sector with astounding profits. The effect of the repeal, along with the general loosening of regulations in the financial sector, on the current financial crisis has been debated for the last three years (and not discussed in this piece).
The advantages of such a move were obvious both in 1930s and are obvious now. Firstly, consumers would not be as directly affected by a bank’s volatile investments. Secondly, it would be cheaper to bailout the retail banks and safer to let the investment bank fail. Lastly, it would be somewhat easier to regulate the banks. The most pressing downside of the move would be the cost of implementing this proposal. Retail banking was never excessively profitable and if banks have to keep a significantly larger reserve, it will raise operating costs. For the U.K. banks, those costs are estimated to be $11 billion annually. Additionally, while the consumers are not directly affected in this new model, it still does not mean that even separated, investment banks could fail in the future without taking down the economy with them. The worldwide interdependence has most certainly increased since the 1930s and so has the sheer size of the investment banks. While the British government promised that there will be no more bailouts, it is entirely possible that even ringed off, such banks would still be too big to fail.
However, ICB was willing to reduce profitability and increase banking costs to assure self-reliance in the private sector. Great Britain faced a daunting realization in 2008: their largest bank was four times the GDP of the U.K. The British government is rightly worried that they might not be able to weather the next meltdown and this would assure that banks would have enough of a cushion to weather serious losses. If our great ancestors are willing to take a page from Roosevelt’s book, should the U.S. be taking a second and third look at the “outdated” policy?