A one-page proposal gaining traction in Congress could turn back the clock on Wall Street 10 years, forcing the breakup of banks, including Citigroup Inc. (C)
Lawmakers in both parties, seeking to prevent future financial crises while soothing public anger over bailouts and bonuses, are turning to an approach that's both simple and transformative: re-imposing sections of the 1933 Glass-Steagall Act that separated commercial and investment banking.
Those walls came down with passage of the Gramm-Leach-Bliley Act of 1999. A proposal to reconstruct them, made by U.S. Senators John McCain and Maria Cantwell on Dec. 16, would prevent deposit-taking banks from underwriting securities, engaging in proprietary trading, selling insurance or owning retail brokerages. The bill could also force the unwinding of deals consummated during the financial crisis, including Bank of America Corp.'s (BAC) acquisition of Merrill Lynch & Co.
"The impact on Wall Street would be severe," Wayne Abernathy, an executive vice president at the American Bankers Association, said in a telephone interview.
Resurrecting Glass-Steagall goes beyond the array of new regulatory powers that President Barack Obama has proposed to fix the financial system. It has also sparked debate among academics, regulators and legislators over whether the Depression-era law could have prevented the crisis of 2008 or might help avoid future ones.
'No Difference'"If you look at what happened, with or without Glass-Steagall, it would have made no difference," said H. Rodgin Cohen, chairman of New York-based law firm Sullivan & Cromwell LLP, who represented one side or the other in more than a dozen transactions stemming from the financial crisis last year, including the rescues of Bear Stearns Cos., Fannie Mae, Wachovia Corp., and American International Group Inc. (AIG)
Cohen and others say the law wouldn't have saved Bear Stearns or Lehman Brothers Holdings Inc., both of which were pure investment banks, from collapse. And the government would not have been able to enlist JPMorgan Chase & Co. (JPM) to take on the assets of Bear Stearns or allow Goldman Sachs Group Inc. (GS) and Morgan Stanley to become bank holding companies, giving them access to the Federal Reserve's discount window.
Rather than split up banks, regulators should provide better supervision and require tougher capital requirements, said Cohen, who was also involved on behalf of banking clients in shaping the bill that dismantled parts of Glass-Steagall.
McCain-CantwellThe McCain-Cantwell proposal, which has picked up four additional co-sponsors, could be considered by the Senate Banking Committee as early as January, if Senator Christopher Dodd, the Democratic chairman from Connecticut, and other members complete negotiations on a financial overhaul bill.
A similar bill has been introduced in the U.S. House of Representatives by Maurice Hinchey, a Democrat from New York. The House already adopted a measure on Dec. 11 to revamp financial regulation without Hinchey's proposal. The chief sponsor of the overhaul measure, Representative Barney Frank, has said he supports giving regulators the power to apply Glass-Steagall in individual cases.
"It is fair to argue that if the bill picks up steam in the Senate, the House could have the political appetite to pass it as well," Paul Miller and four other analysts at FBR Capital Markets in Arlington, Virginia, said in a Dec. 17 note.
One reason support for the idea is growing is that lawmakers see public anger building over what Obama called "fat cat bankers." As industry profits bounce back and banks repay Troubled Asset Relief Program funds—and also get set to hand out billions of dollars in bonuses—Americans are still struggling with a 10 percent unemployment rate and home foreclosures. That's leading Congress to seek ways to rein in the firms blamed for the financial crisis.
'At War'"Congress is at war with Wall Street," said former Fed Governor Lyle Gramley, now a senior economic adviser at Soleil Securities Corp. in New York. "They perceive Wall Street as being the root source of our financial crisis, and they want to do something to make sure that doesn't happen again."
Splitting banking functions needed for the smooth operation of the economy from riskier securities and trading activities was proposed earlier this year by the Group of Thirty, a nonprofit organization made up of former government officials and bankers, including Paul Volcker, a former Fed chairman and head of the president's Economic Recovery Advisory Board.
The group said the crisis spread like a contagion from firm to firm, putting both commercial banks and securities companies at risk. To prevent a domino effect, systemically important financial institutions shouldn't be allowed to engage in proprietary trading that involved "particularly high risks" or "serious conflicts of interest," the group said.
'Failed the Test'While that would not bar banks from underwriting securities, as some U.S. lawmakers want, it might force them to shutter or sell trading divisions. The financial system has "failed the test of the marketplace," Volcker said in January. He added that "it's been proven that they're unmanageable, the existing conglomerates."
Some Wall Street executives endorse such a split.
"What we need is a 21st century Glass-Steagall," said Gerald Rosenfeld, deputy chairman of Rothschild North America Inc. and a professor of business and law at New York University.
Rosenfeld favors regulating commercial banks like public utilities, while giving securities firms and hedge funds more freedom, as long as they adhere to capital guidelines.
"The important thing is we have to have a structure that prevents the contagion from spreading when there are catastrophic losses in those riskier businesses," he said.
Smaller Is BetterOthers are guided by the principle that smaller is better. Christopher Whalen, managing director of Institutional Risk Analytics, a Torrance, California, firm that evaluates banks for investors, said the repeal of Glass-Steagall in 1999 was based on the false premise that bigger banks would be more competitive and efficient.
"I don't think there are any efficiencies of scale in banking," Whalen said. "Making them smaller would be far more efficient and also improve competition. If we had broken up Citi last year, we would have seen a couple of new market entrants buying operations. That is what creative destruction is all about."
Roy Smith, a finance professor at New York University's business school and a former Goldman Sachs partner, said reviving Glass-Steagall would affect Goldman Sachs less than other big banks because the firm focuses largely on investment banking and could give up banned businesses without difficulty.
'Unwanted Stepchild'For other firms, the fallout could be harsh, said Abernathy of the bankers' association.
"If you restore Glass-Steagall, for some of them the banking operation would be an unwanted stepchild," he said. "It would be the less profitable of the two because its business would be far more constricted."
Bank lobbyists are targeting the Senate Banking Committee as lawmakers negotiate provisions of a regulatory overhaul bill. They're arguing that a return to the pre-1999 era would reduce the diversity of revenue streams, make financial firms more vulnerable in a crisis, prevent them from acquiring ailing institutions, increase the cost of raising capital and undermine the global competitiveness of U.S. institutions.
"Reinstating Glass-Steagall misses the mark—a point we intend to share with Chairman Dodd and other senators on the committee," said Rob Nichols, president of the Financial Services Forum, a Washington-based trade group that represents the chief executive officers of the largest financial firms.
Dodd said he doesn't favor reviving Glass-Steagall as a way of dealing with "too-big-to-fail" institutions and added "there are other things we can do to break them up."
Leach, GrammAlso lining up on the side of the banks are two sponsors of the 1999 bill that dismantled Glass-Steagall. Jim Leach, a former Republican congressman from Iowa and now chairman of the National Endowment for the Humanities, said the biggest problem was overleveraging by securities firms, not the mingling of businesses.
"Virtually all of the financial difficulty banks are in today relates to activities they could do before" President Bill Clinton signed his bill in 1999, Leach said.
Phil Gramm, who as a Republican senator from Texas was another co-sponsor, said that, rather than weakening banks, the law cushioned the impact of the subprime mortgage crisis by making financial institutions more broad-based and competitive.
"A lot of this is about trying to find somebody to blame," said Gramm, now a vice chairman of investment banking at UBS Securities LLC.
'Political Dynamite'Hinchey, the congressman who introduced the House bill to reinstate Glass-Steagall, said in an interview that a comeback is "very questionable."
"There's a lot of pressure coming from the big banks to prevent this kind of thing from happening," Hinchey said.
Those banks may have lost some of their political influence as their earnings have recovered, said William Isaac, a former chairman of the Federal Deposit Insurance Corp. "The TARP legislation and the way it was administered was political dynamite for the banks," said Isaac, now chairman of the global financial services unit of LECG Corp., an economic and financial consulting firm in Emeryville, California. "The public feels that this was all about protecting Wall Street and did nothing for Main Street, and it's largely true."