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The Case for Banking Regulation

4 minute read
Rana Foroohar

Here’s an underreported fact that tells you a lot about the JPMorgan Chase fiasco and the state of banking regulation four years after the financial crisis. Between the time the Dodd-Frank financial-reform act became law in July 2010 and the first proposed regulations were published in October 2011, staffers at the Fed, Treasury, FDIC, CFTC and SEC met with outside groups and people with vested interests to discuss how the new law would read.

And just who was bending the regulators’ ears? A vast majority of their meetings–93%–were with folks in the financial industry. A mere 7% were with public-interest, labor, advocacy and research groups. At the very top of the meeting agenda was JPMorgan, which met with federal regulators 27 times. Jamie Dimon himself got face time. Your average citizen? Not so much.

Much of that bank lobbying power has been used to transform Dodd-Frank’s now famous Volcker Rule, which attempts to limit high-risk financial gambling by the banks, into the Vapor Rule–mostly air. Not only is there a loophole to allow the sort of portfolio hedging that may have resulted in JPMorgan’s massive loss (estimates of which have jumped to around $4 billion from $2 billion over the past week); there’s also one to create wiggle room for banks to define high-risk activities so that they fall within the law’s parameters.

Dodd-Frank was supposed to be a way of capturing the spirit of the Glass-Steagall banking law, enacted in 1933 to prevent a repeat of the stock speculation that led to the Depression. Until its weakening and ultimate repeal in 1999, Glass-Steagall split commercial banking–meaning plain-vanilla lending to real people–from the riskier if mostly routine trading done by investment banks like Morgan Stanley. The idea was to federally insure banks and have them handle deposits and consumer and business lending while investment banks (along with hedge funds) did the higher-risk, higher-profit trading. Our deposits were safe, while rich people were free to invest as they pleased in uninsured institutions.

But under constant assault by the banking lobby, Dodd-Frank retreated from that goal, which is why a small but vocal group of economists, politicians and activists are asking whether we shouldn’t restore Glass-Steagall, or put in place something like it, as a way of making banking safer. As Senate candidate from Massachusetts Elizabeth Warren puts it, “Banking should be boring, and that’s inconsistent with trading.”

It’s a debate worth having, though not for the reasons you might think. During the financial-reform discussions in 2009, the possibility of reviving Glass-Steagall was raised and then quickly rejected, in part because the first institutions to fail were investment banks and an insurer–Bear Stearns, Lehman Brothers, AIG–not conglomerates that combined commercial and investment banking.

Yet to discard Glass-Steagall as a regulatory option is to miss the point, and not just because JPMorgan does both retail and investment banking. We typically demand regulation that addresses the previous crisis (which is never the same as the next one) or in some cases the current one. Instead we should be looking for the best overall ways to make the financial system less risky, especially for the general public.

To be fair, Glass-Steagall isn’t foolproof or even banker-proof. Risk will always be with us. Even plain-vanilla commercial lending can be risky if bankers relax their standards–remember the S&L crisis? JPMorgan was actually trying to hedge the risk of ordinary loans’ going south. But, says derivatives expert and law professor Frank Partnoy, “splitting commercial banking from trading dramatically simplifies risk,” since the former is more about knowing your customer and making decent lending bets rather than trying to keep track of a $360 billion investment portfolio that includes thousands of complicated hedges.

Bankers argue that the ability to hedge reduces that portfolio risk. But it brings us back to the too-big-to-fail problem–or maybe it’s more too big to manage. “No human can understand the complexity of all the transactions that these banks are engaging in daily,” says MIT professor Simon Johnson, an expert on financial regulation and an advocate for Glass-Steagall. “If Jamie Dimon, the best risk manager in the business, can make a mistake like this in a benign market environment, what happens to lesser managers when Greece fails? Or when the euro collapses?”

Who wants to find out? I’m all for re-examining the merits of Glass-Steagall and how it might be updated for today’s market. The financial industry thinks it can continue to do business as usual and assume that we’ll foot the bill when it all goes sideways. Having witnessed one meltdown, that’s a risk I don’t want to underwrite.

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