⚠️Automatic translation pending review by an economist.
The financial crisis of 2007-2009 highlighted the weaknesses of the global banking system. From the securitization of subprime mortgages to the failure of soft regulation, from the excessive risks taken by financial operators to the systemic nature of certain banking establishments, various explanations have been put forward to explain the crisis and, above all, to understand what measures need to be put in place in the future, both to prevent and to curb such dysfunctions.
Among these measures, the introduction of a new Glass Steagall Act seems particularly appealing, both to the political world and to certain economists. However, its real effectiveness is doubtful, as its contribution is as uncertain as it is mitigated.
The Glass Steagall Act or Banking Act was established in 1933 in the United States under the Roosevelt administration as part of the New Deal. One of its aims was to separate deposit banks from investment banks. This law was repealed in 1999 by the Financial Services Modernization Act.
It is undeniable that the fact that certain banks have considerably increased their « size » over the past twenty years has greatly weakened and threatened the stability of the financial system, and by knock-on effect, the real economy. Introducing a new Glass Steagall Act would therefore help to minimize the size of banking institutions and prevent a bank’s investment activities from spilling over into their customers’ deposits, which is laudable.
A dubious effectiveness for a mixed result
However, separating investment activities from deposit-taking activities would not necessarily have the expected results. Not all the banks that failed during the crisis were universal banks: the best example is Northern Rock in the UK, a major deposit-only bank that failed before being nationalized in February 2008.
What’s more, over and above the bailouts and aid packages provided to banks, some banks proved more resilient than others, thanks to their diversified structure. This diversification has enabled them to offset losses in one business sector against the performance of others. It is currently very difficult to accurately measure the contagion effects within such large financial institutions. It is therefore difficult to draw conclusions on the benefits of separating bank activities. It would even seem that it could contribute to the weakening of certain banking establishments.
At no point do the debates on a new Glass Steagall Act address the delicate question of how to manage the links between banks and hedge funds, which are an obvious source of systemic risk and chronic future instability; nor are bank bailouts considered, despite the fact that they have cost nearly $14,000 billion, mainly in the United States, Europe and Great Britain (i.e. a quarter of global GDP).
In search of more effective compromises
A return to the Glass Steagall Act does not appear to be an effective solution to the intrinsic problems of bank size and deposit protection. It is too radical, has no proven effectiveness and is undoubtedly too restrictive, which would run the risk of affecting the banking system and the real economy.
Several compromises have been proposed in recent years, mainly but not exclusively in economic literature. Their objectives can be summed up as a common desire to avoid repeating the same mistakes as in the past, while at the same time trying to improve the soundness of the financial system, or at least the banking system, by encouraging banks to move towards greater market discipline. The aim here is not to draw up an exhaustive list of these proposals, but to present those that represent the most effective and attractive approaches.
These include the Volcker Rule, which emerged from the Dodd-Frank Wall Street Reform and Consumer Protection Act in the USA in 2010. This rule is gradually overtaking the Glass Steagall Act in Anglo-Saxon countries, and is becoming increasingly popular in the Eurozone.
It can be briefly summarized by its two main components: the first prohibits any banking entity from investing in hedge funds; the second stipulates that banks may not invest their funds for their own account or against the interests of their clients. On the other hand, deposit banks, insured against the risk of default, will be prohibited from acquiring or merging with another bank. The Dodd-Frank Act appears to be more relevant and effective than the Steagall Act, and thus meets the dual objectives mentioned above.
Even if the separation of banks’ investment and deposit activities is not the best solution to adopt, it may prove to be an excellent « threat », in the sense that banks will have to internalize their externalities, if they do not want to see themselves dismantled. This is what is proposed by Richard J. Herring, Professor of Finance at the Warton School of Pennsylvania, with his idea of Wind-Down Plans.
The plan would require banks to map out their various activities and subsidiaries, their interconnections and their exposures. It would then specify how, in the event of a high risk of internal contagion, the banks could separate these activities, without jeopardizing their overall management and structure, or the markets. Once this plan has been drawn up, it will have to be assessed and validated by a supervisor (a central bank?), on pain of heavy sanctions or a ban on operating. Banks will then be better able to self-manage and move towards greater market discipline, given the sword of Damocles hanging over their heads. It is even conceivable that such plans will make it possible to monitor banks more closely, and to take steps ex ante to minimize the likelihood of having to resort to a bailout at a later date.
The question of a new deposit insurance design
While it may not seem necessary to separate banks’ deposit and investment activities at present, a new, more in-depth architecture for deposit guarantee funds (DGFs) is more than necessary. Indeed, the problem of deposit insurance is a complex one, and the recommendations of the Glass Steagall Act do nothing to resolve it; on the contrary, they neglect it.
FGDs are an essential component of the financial safety net, ensuring the solvency of banks and the protection of even the most unsophisticated deposits. There is no such thing as a perfect DGS model, and the possibilities are manifold: co-insurance models, public/private partnerships, deposit guarantees in foreign currencies, implicit contracts, etc. The ideal would be to increase deposit insurance coverage, but it has been amply demonstrated that overinsurance weakens banks by promoting moral hazard: depositors who know they are strongly covered ex ante will tend to take maximum risk ex post.
In the European Union, the FGD directive requires that each account be insured for at least €20,000 per depositor; in the United States, deposit coverage limits have reached $200,000. A summary of the economic literature on the subject highlights a number of points that cannot be ignored when designing a good architecture: a coverage limit system that is consistent with the country’s economic characteristics, compulsory membership of the institutions concerned by the guarantee system, a hybrid private/public partnership, strong autonomy and responsiveness on the part of FDGs to avoid bank runs (and the intervention of public funds that would weigh on the resulting deficit) and, last but not least, a strengthening of banking supervision over the prices and services provided by FDGs.
References
Asli Demirgüç-Kunt, Edward J. Kane & Luc Laeven (2006), « Deposit Insurance Design and Implementation: policy lessons from research and Practice ».
Asli Demirgüç-Kunt, Edward J. Kane (2002), « Deposit Insurance Around The Globe: Where Does It Work? ».
Dodd-Frank Wall Street Reform and Consumer Protection Act (2010).
Morris Goldstein & Nicolas Véron (2011), « Too Big To Fail: The Transatlantic Debate », Bruegel workink paper.
Robin Greenwood, Augustin Landier and David Thesmar (2011), « Vulnerable Banks. »
Richard J. Herring (2010), « Wind-down Plans as an alternative to Bailouts, The Cross Border Challenges ».
Richard J. Herring and Jacopo Carmassi (2010); « The Corporate Structure of International Financial Conglomerates: Complexity and its Implications for Safety and Soundness »; In The Oxford Handbook of Banking.
Johnson, Simon, and James Kwak (2010), 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. New York.
Asli Demirgüç-Kunt, Edward J. Kane (2002), « Deposit Insurance Around The Globe: Where Does It Work? ».
Dodd-Frank Wall Street Reform and Consumer Protection Act (2010).
Morris Goldstein & Nicolas Véron (2011), « Too Big To Fail: The Transatlantic Debate », Bruegel workink paper.
Robin Greenwood, Augustin Landier and David Thesmar (2011), « Vulnerable Banks. »
Richard J. Herring (2010), « Wind-down Plans as an alternative to Bailouts, The Cross Border Challenges ».
Richard J. Herring and Jacopo Carmassi (2010); « The Corporate Structure of International Financial Conglomerates: Complexity and its Implications for Safety and Soundness »; In The Oxford Handbook of Banking.
Johnson, Simon, and James Kwak (2010), 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. New York.
