PROHIBITIONS ON PROPRIETARY TRADING WILL BE HARD TO ENFORCE. THERE’S A BETTER WAY.
OPINION
Federal deposit insurance was enacted in the 1930s to prevent runs on banks by giving nervous depositors confidence that Uncle Sam would protect their money. But Congress was not about to let federally insured commercial banks trade, underwrite and speculate in securities or commodities. That’s why the Glass-Steagall Act, which created federal deposit insurance, also separated commercial and investment banking.
Congress repealed the provisions of Glass-Steagall separating commercial banks and investment banks in 1999. Unfortunately, the government remained in the business of insuring bank deposits. And that helped set the stage for the financial system breakdown in 2008—as well as the flawed Dodd-Frank Act of 2010, whose prohibitions on trading activities will be hard to understand and enforce.
When it repealed Glass-Steagall, Congress already had an example of what could go wrong. In the 1980s, after it loosened restrictions on federally insured Savings and Loan companies, more than 1,000 of them collapsed. This ended up costing American taxpayers more than $100 billion. But Congress chose to ignore that lesson.
Instead of retaining federal deposit insurance, Congress should have permitted the market to create a system of private guarantors of bank deposits. It would have been consistent and intellectually honest (but politically impossible) to repeal both sections of Glass-Steagall: federal deposit insurance as well as the separation of investment and commercial banking. Whenever a nation privatizes profits while it socializes losses, no societal good can be achieved.
In 1990, the Securities Industry Association (SIA then and now called Sifma), which represented all the nation’s investment banking firms, proposed federal legislation that would have permitted separately capitalized investment banking subsidiaries of bank holding companies to compete with traditional investment banks—but with strong firewalls to prevent access to federal deposit insurance.
Such investment banking subsidiaries could succeed or fail with no help or hindrance from the government in the same manner as independent investment banking firms. The SIA plan was never adopted by Congress.
Instead, after the repeal of Glass-Steagall, commercial bank holding companies eventually housed their investment banking operations in their federally insured banks. And it was in such banks where bank holding companies located the vast majority of their derivative trading business.
This is not surprising. The ratings agencies rate the bank holding companies’ federally insured banks several notches higher than the holding companies themselves. And with higher credit ratings, significantly less capital is legally required to trade such instruments.
This situation would have been prohibited under the SIA plan. To protect the taxpayer, trading activity would have to be done in a separately capitalized subsidiary of the bank holding company.
As a result of the world-wide financial debacle over the last few years, key elements of the SIA plan are being considered for adoption today in the United Kingdom, based on the recommendations of the Vickers Commission, headed by Sir John Vickers. The British government seems serious about adopting it.
The Vickers plan is essentially the old SIA plan. Where we used the term “firewalls” to segregate the riskier businesses from government insured deposit taking, they call it “ring fencing.” The concept is the same.
Congress should take another look at the SIA plan or the Vickers plan, both of which are simpler and cleaner than Dodd-Frank’s prohibition of federally insured banks from engaging in proprietary trading. The intractable difficulty with this so-called Volcker rule is to distinguish between a bank’s permitted hedging and market making activities, which are legal, with proprietary trading, which is not.
Should the banks get into trouble again, American taxpayers will not stand for another bailout by Congress. Instead we’ll have to rely on the “living wills” section of the Dodd Frank law to provide for orderly wind-downs of failing federally insured banks. But no one knows how or if these living wills would work—and what would happen if the contagion from such failing banks were to spread rapidly within the system as it did in 2008.
Mr. Downey is a former chairman of the Securities Industry Association.
A version of this article appeared August 1, 2012, on page A11 in the U.S. edition of The Wall Street Journal, with the headline: How to Avoid Another Bank Bailout.
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