Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Main Street doesn’t ordinarily concern itself with the minutiae of banking regulation, but ever since the 2008 financial crisis, one Depression-era banking law has stuck in the public imagination but probably shouldn't.

I’m talking about Glass-Steagall, the 1933 law that separated commercial and investment banking. Main Street contends that its repeal in 1999 contributed to -- or even caused -- the near-collapse of the financial system and that it should be resurrected. Wall Street, of course, disagrees.

Against that backdrop, Gary Cohn -- White House economic adviser and former president of Goldman Sachs -- shocked the world last month when he told a group of senators that he supports the return of Glass-Steagall. Cohn’s comments echo President Trump’s campaign promise to bring it back.  

As Bloomberg News reported on Thursday, however, Wall Street doesn’t seem concerned. And neither does the market. The S&P 500 Financials Index gained 0.6 percent on April 6, the first day of trading after Cohn’s comments came to light. The index is also up 1.4 percent since April 5 through Friday.

Which raises the question: If Glass-Steagall is so important, then why the muted reaction to Cohn’s comments? According to Senator Bob Corker, the reason is that there isn’t a lot of “momentum” around the issue. But there’s a better answer. Namely, Glass-Steagall isn’t the magic bullet that Main Street thinks it is.     

Let’s start with Glass-Steagall’s origin. “It was founded on a false premise,” says Rodgin Cohen, senior chairman of Sullivan & Cromwell and my mentor at the firm. Senator Carter Glass initially blamed the securities activities of banks for the collapse of the banking system and thought that separating commercial and investment banking would result in a more stable financial system. But Glass soon came to question those assumptions. By 1935, he wanted to allow commercial banks to underwrite corporate bonds.    

Glass wasn’t the only one who would have second thoughts. Regulators defanged Glass-Steagall long before it was formally repealed. Beginning in the 1960s, they permitted banks’ affiliates -- and in some cases banks themselves -- to deal in securities. The thin armor of Glass-Steagall spilled into view in 1998 when Citibank, a commercial bank, merged with Salomon Smith Barney, an investment bank. The repeal of Glass-Steagall a year later was largely form over substance.

Lost Decades
The U.S. financial sector hasn't moved much since Glass-Steagall was repealed in 1999
Source: Bloomberg

So it isn’t true -- contrary to widespread perception -- that greedy bankers were behind the repeal of Glass-Steagall. In fact, banks have been worse off since then. Return on common equity for the S&P 500 Financials Index averaged 14.5 percent from 1990 to 1999 -- the earliest year for which numbers are available. Since Glass-Steagall was repealed, however, ROCE has averaged just 9.4 percent. Other measures of profitability, such as return on assets and return on capital, are down, too.

Richer Before
The repeal of Glass-Steagall in 1999 hasn't been a windfall for U.S. financial firms
Source: Bloomberg

Also, the market placed a higher value on financial firms before Glass-Steagall was repealed. The price-to-book ratio of the Financials Index -- a commonly used valuation metric for banks -- averaged 2 times from 1990 to 1999. Since then, the P/B ratio has averaged 1.7 times.

Cheaper After
The market valued U.S. financial firms more highly before the repeal of Glass-Steagall in 1999
Source: Bloomberg

Still, many assume that Glass-Steagall would make banks safer, but there’s little evidence for that. Economic historians have since vindicated Glass’s conclusion that the banks’ securities activities did not cause the collapse of the banking system in the 1930s. Nor did the repeal of Glass-Steagall have much to do with the 2008 financial crisis. Even if Glass-Steagall had been on the books and strictly enforced in 2008, it most likely wouldn’t have eased -- never mind prevented -- the crisis. As former Federal Reserve Chair Ben Bernanke has said, “Plenty of firms got into trouble making regular commercial loans, and plenty of firms got into trouble in market-making activities. The separation of those two things per se would not necessarily lead to stability.”

There are better ways than Glass-Steagall to make the financial system safer. Raising capital requirements is one. Imposing limits on the size of banks -- rather than on their activities -- is another. If anything, limiting the variety of banks’ activities makes their businesses less diversified and therefore riskier.     

Glass-Steagall isn’t -- and never was -- a panacea for bank stability. No wonder Wall Street and the market are tuning out all the carping about bringing it back.   

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net