The case for banking reform

No More Bailouts by Taxpayers

Robert N. Downey
Founder, Better Banking Law

Delivered at Dartmouth College, June 11, 2013; NYU Law School, September 30, 2013; the American College Penn Mutual Center Financial Services Conference, August 21, 2015; and the Bohemian Club, May 18, 2016. Though abbreviated versions were presented, the following is the full text of the updated address. A PDF of "The Case" can be downloaded here.

Two words: “Glass Steagall” have been known to elicit vehement and contentious responses. One may have read
or heard the above phrases (and variations thereof) in the financial press or on the lips of lobbyists, politicians, and others in reference to the “archaic” notion of retail banking being separate from investment banking. For those that support this view, I would pose one question: is Federal Deposit Insurance also an “archaic” idea? What is missed by most is that there are two parts to Glass Steagall, both of which were particularly crafted in tandem to prevent a repeat of The Great Depression. I will shortly describe this in more detail, but I would first like to relay how I came to be involved with this subject.

I’ve worked in the securities industry for over 50 years, the last 46 with Goldman Sachs. Nothing in my business career was as important as the role I played many years ago as the lead defender, on the part of the independent securities industry, of The Banking Act of 1933, which created Federal Deposit Insurance and is more commonly

called the Glass-Steagall Act, the names of its Senate and House co-authors. Messrs. Glass and Steagall sure knew what they were doing in 1933. If commercial banks were to enjoy Federally insured deposits (Part I of Glass Steagall), they certainly should not be speculating with Uncle Sam’s money. So, in addition to creating the FDIC, Congress also separated commercial banks from investment banks (Part II of Glass-Steagall). Unfortunately, those provisions were severely weakened by Federal banking regulators over the years, and the few remaining provisions of Part II were eventually repealed by Congress in 1999.

To my knowledge, there have been few if any calls to repeal Part I, the Federal Deposit Insurance aspect of the Glass-Steagall Law. It was instituted to prevent runs on banks by nervous depositors by giving such depositors confidence that Uncle Sam was the ultimate protector of their money. It certainly was not created to permit

Federally insured banks to trade, underwrite and speculate in securities or commodities, let alone so-called derivatives.

As I stated, by the time Congress decided to repeal those few remaining provisions in Glass-Steagall that

separated investment banking from commercial banking, most of the damage had already been done based not on any amendments to the law, but solely on prior decisions by Federal banking regulators, primarily the Federal Reserve Board. In effect, the Fed determined that when Congress passed The Banking Act of 1933 (the Glass-Steagall Law), they did not really mean what the law they had just enacted clearly stated. The tragedy was that at the time the Fed took such actions, there was no person or industry group that had the financial resources, the incentive, or the inclination to challenge the Fed in court on behalf of the American taxpayers. To my recollection, Congress failed to even hold meaningful hearings on the Fed’s deregulatory activism.

What a crying shame! Congress surely had the perfect example of what could go horribly wrong when the

Federally insured Savings and Loan companies were given additional powers by Congress in the late 70s and early 80s. By the mid to late 1980s, more than 1,000 S&Ls had collapsed costing American taxpayers more than $340 billion according to a 1996 estimate by the General Accounting Office. Why did the banking regulators and later the Congress choose to ignore that obvious history lesson?

When Congress finally repealed Part II of Glass-Steagall, it seemed as though it was no big deal since, except for the insurance provisions, Part II had already been effectively repealed de facto by the banking regulators. Thus, there was little opposition to de jure repeal in Congress and it passed by an overwhelming majority. But that action was also a tragedy. Without the Congressional repeal, two positive developments might have taken place: (i) a future, more enlightened Federal Reserve Board might have seen the errors of its predecessors’ ways and reversed those prior decisions, or (ii) a suit on behalf of concerned taxpayers might have taken the issue to court and won based on the Fed’s misinterpretation of the clear intent of the Glass-Steagall statute.

In defense of the Fed’s deregulatory actions in the late 1980s and early 1990s, which dismantled Part II of

Glass-Steagall by fiat, such actions were encouraged by a fair number of economists and by editorials in much of the financial press, including The Wall Street Journal and The New York Times. And even in recent years,

The Economist, Financial Times and other sophisticated financial publications have referred to the Glass-Steagall law with such derogatory terms as “that Depression era statute” and “that relic of the thirties.” Of course they were all referring to Part II, not Part I.

Why did none of these economists, editorial writers, Federal banking regulators or Congress itself advocate for the repeal of those Part I provisions that provided for Federally insured deposits as well as the Part II provisions? Why indeed did the financial press and Congress fail to refer to the FDIC as a “relic of the thirties”? Instead of retaining Federal Deposit Insurance, why didn’t Congress permit the market to create a system of private (not governmental) guarantors of bank deposits and get Uncle Sam out of the business of insuring deposits? It would have been entirely consistent and intellectually honest to repeal both sections of Glass-Steagall: Federal Deposit Insurance as well as the separation of investment and commercial banking. But of course it would have been politically near impossible to have done so. It is hard to imagine a member of Congress running for re-election based on having voted to repeal that “relic of the thirties,” Federally Insured Deposit Insurance.

As a result of those earlier actions by the Fed, and then the repeal by Congress itself of those provisions which separated investment banking from commercial banking while retaining Federal Deposit Insurance, and the subsequent debacle in the financial markets in late 2008 and early 2009, aside from a few strong regionally headquartered investment banking firms and a few New York-based boutique advisory firms, there no longer exists a vibrant, independent securities industry in the United States.

Think of it. Of the five largest independent securities firms five years ago, Bear Stearns, about to fail in early 2008, was absorbed by J.P. Morgan with strong encouragement by the US Treasury and the Federal Reserve and immense financial help from the Fed; Lehman Brothers went bankrupt; a shaky Merrill Lynch was bought by Bank of America; and shortly thereafter the two strongest, Goldman Sachs and Morgan Stanley, were firmly encouraged by the Fed and the Treasury to become, and quickly became, bank holding companies.

A little aside here… Though I am a Senior Director of Goldman Sachs (which, as I said, is now a bank holding company), this is primarily an honorary title; I have not been active with Goldman since before the firm went public in 1999. Therefore, although I have been associated with The Firm since I joined it in 1969 and have immense affection and respect for The Firm, its leadership and the integrity of its people, please understand that I am not speaking for Goldman Sachs in any way. The following comments are solely my own views.

Another aside… As a matter of fact, unless current banking laws were to be reformed by Congress, Goldman Sachs would be foolish to give up its present structure as a bank holding company with its “Too Big To Fail” status and then try to compete with “Too Big To Fail” bank holding companies such as JP Morgan, Citigroup, Bank of America and Morgan Stanley. It would be unilateral disarmament.

As everyone knows, the financial world has been through the wringer for the past five years. There were many causes of the financial crisis of 2008:

1. Toxic mortgages consisting of liar loans brought to market by unscrupulous mortgage brokers which were then securitized and repackaged by Wall Street banks and securities firms;
    
2. Careless and sometimes venal individual borrowers that took on debts which they didn’t understand but knew they couldn’t afford unless the housing bubble continued to expand;
    
3. Credit rating agencies which blessed many hundreds of questionable mortgage backed securities issues with their highest ratings of AAA, the same rating they gave to United States Treasury securities;
    
4. Irresponsible lending by Fannie Mae and Freddie Mac (at that time investor owned but characterized as U.S. government sponsored enterprises) which lowered their own credit standards so as not to lose market share to Wall Street;
    
5. Federal regulators that failed to do their jobs;
    
6. And, of absolutely vital importance the fact that, due to the initial deregulation by banking regulators and then to the final repeal of the Glass-Steagall Act in 1999, large Federally insured banks (considered "Too Big To Fail") could and did speculate in mortgage backed securities and derivatives underwriting and trading just as non-Federally insured investment banking firms did.

One of the most compelling arguments against those who minimize the risks involved in underwriting securities can be gleaned from articles in August 2012 in The New York Times and The Wall Street Journal which described a $590 million settlement by Citigroup with its stockholders.

Apparently, according to The New York Times, “Citigroup represented that subprime exposure in its investment banking unit was $13 billion or less, when in fact it was more than $50 billion.” Had the bank not been permitted to underwrite securities how on Earth would it ever have had even $1 billion of these toxic assets in inventory, let alone $13 billion, or God forbid, more than $50 billion. Since the articles also point out that the bank underwrote some $70 billion of collateralized debt obligations from 2004-2008, the conclusion of where most of those assets came from is inescapable. See the accompanying “Debt Craze” table for further evidence. Also worth note is that commercial bank’s exposure was far greater than that of investment banks, as shown above.

When considering the gigantic losses that Citigroup suffered from underwriting C.D.O.’s and other mortgage-backed securities, I recall with more than mild bemusement the arguments that the banks and their surrogates employed to convince their banking regulators to dismantle Part II of Glass-Steagall. They essentially argued that, since underwriting securities was a virtually riskless business, banks should be permitted to underwrite and trade them because the profits they earned therefrom would serve to more fully protect taxpayers. The real world result of course was just the opposite, requiring a $45 billion bailout of Citigroup by America’s taxpayers.

Whenever a nation privatizes the gains while it socializes the losses, no societal good can be achieved...

That is unless the lessons learned set us on a new, sensible path where failure is permitted as well as success. And for failure to be at all meaningful, not just stockholders but unsecured bondholders and other lenders must also suffer losses, as was the case when Lehman Brothers went bankrupt. Otherwise, lenders will have no incentive to lend wisely. No private institution, financial or otherwise, should be considered “Too Big To Fail.” Unfortunately, that’s today’s world. Just consider the bailouts by American taxpayers of the S&Ls some 25 years ago and, more recently, Fannie Mae, Freddie Mac, AIG, Citigroup, Bank of America, the nation’s money market funds and others.

The following table indicates that, during the 40-year period between 1970 and 2010, the assets of the five largest American banks, as a percentage of total industry assets, more than tripled. Since 2010, such banking concentration has substantially increased, with a result that those five banks and a few others (constituting over two-thirds of total US bank assets) are now considered “Too Big To Fail.”

Part II of the Glass-Steagall Act worked effectively for over 50 years in the United States with hundreds of investment banks, large and small, being allowed to fail, without a penny of taxpayers’ money expended (such as giant Drexel Burnham which, at the time of its failure, dominated the high yield corporate bond market). A good number of commercial banks also failed, including a large one, Continental Illinois Bank in 1984, but they were taken over by the FDIC. Nonetheless, in spite of the many examples of failure by investment banks, the large Federally insured commercial banks were relentless in their desire to engage in the risk-taking that non-insured investment banks were permitted under Part II of Glass-Steagall.

Initially those banks lobbied their regulators to interpret the law in a manner that would allow them to underwrite and trade municipal revenue bonds since they were already permitted to underwrite municipal general obligation bonds secured by taxes. They initially only wanted revenue bonds. Later, they sought and won the power to underwrite and trade corporate bonds and mortgage-backed securities, and eventually, equities.

Unfortunately, the Federal banking regulators allowed them to do so. The only way the securities industry could prevent this was to take the banking regulators to court. But that soon came to be prohibitively expensive. The independent securities firms simply could not afford to defend Part II of Glass-Steagall in that manner, so we proposed a reasonable alternative that permitted commercial banks to engage in investment banking.

Some 23 years ago, as Chairman of the Securities Industry Association (which then represented all the nation’s investment banking firms, large and small), I proposed Federal legislation – supported unanimously by the SIA Board – which would have permitted separately capitalized investment banking subsidiaries of bank holding companies to compete with traditional investment banks, but with very strong firewalls to prevent access to Federal Deposit Insurance. The proposed legislation, the SIA Plan, was drafted in 1990 primarily by the Securities Industry Association’s highly qualified outside counsel, Francis X. Meaney, then President of the international law firm, Mintz Levin.

The staunch Congressional defenders of the Glass-Steagall separation of investment from commercial banking were, not surprisingly, extremely disappointed in the SIA’s decision. I remember a day in 1989 when the late Dick Fisher, then CEO of Morgan Stanley and Vice Chairman of the SIA, and I had a rather tense meeting with Congressman John Dingell of Michigan, the then very formidable Chairman of the House Energy and Commerce Committee.

We explained that, since the SIA could no longer afford to sue the Fed and the US Controller of the Currency every time they bestowed an additional underwriting power on the commercial banks in violation, in our view, of the clear intent of the Glass-Steagall statute, we were forced to go in a different direction. Chairman Dingell was clearly upset with us but reluctantly agreed that we had no choice but to pursue our proposed alternative.

Incidentally, the SIA later merged with the Bond Market Association and is now called the Securities Industry and Financial Markets Association (SIFMA), and today is dominated by bank holding companies.

Under the SIA Plan of 1990, such investment banking subsidiaries could succeed or fail with no help or hindrance from Uncle Sam in the same manner as independent investment banking firms. Seems pretty simple! Unfortunately, that simple plan was never adopted by Congress. The commercial banks fought it tooth and nail, since supporting it would mean the loss of their unfair advantage in pursuing investment banking business as Federally-insured banks. Instead, they continued to successfully advocate for more trading and underwriting powers through the intercession of their regulators and for the eventual repeal by Congress of Part II of Glass-Steagall through their lobbyists.

Moreover, the commercial bank holding companies’ lobbyists succeeded, in truly spectacular fashion, in having a large portion of their investment banking operations housed primarily in their Federally insured banks rather than as separately capitalized investment banking subsidiaries which would succeed or fail with no access to Federal Deposit Insurance. Think of what that means. The credit ratings agencies rate the bank holding companies’ Federally insured banks several notches higher than the holding companies themselves.

It is not difficult to conclude where most large bank holding companies locate the vast majority of their derivative trading businesses. The Federally insured bank subsidiary, of course, because with higher credit ratings significantly less capital is required to trade such instruments. That location would have been prohibited under the SIA Plan. In order to protect the taxpayer, such activity would have been required to be executed in the separately capitalized, non-Federally insured investment banking subsidiary of the bank holding company. Unfortunately, the SIA Plan was never enacted.

However, as a result of the worldwide financial debacle over the last several years, the key elements of the SIA Plan have now become law in the UK, based on Sir John Vickers’ Commission’s recommendations. I had a very productive meeting in September 2012 with Sir John in Oxford where he serves as the Warden of All Souls College. (In the US, he would be its president or provost). While in the UK, I also visited with influential officials of Her Majesty’s Treasury and the Bank of England. They all seemed determined to go forward with the separation of commercial and investment banking, and, despite vehement opposition from the UK’s bank lobbyists, they succeeded.

We are gratified that the Vickers plan, essentially the SIA Plan of 1990, is now law in the UK and is being phased in. Where we used the term “firewalls” to segregate the riskier businesses from government insured deposit taking, they use the term “ring fencing” and they ring fence the retail bank rather than the investment bank, but the concept is the same.

In addition to the SIA Plan and the Vickers Plan, the European Union is considering a plan offered by an expert group chaired by Erkki Liikanen, Governor of Finland’s Central Bank, to make the EU’s banks safer. The Liikanen Plan is similar to the SIA Plan but is, not surprisingly, being vehemently resisted by the Universal Banks of Europe.

When the Dodd-Frank legislation was being drafted by Congress a couple of years ago, apparently neither the SIA Plan nor anything similar to the Vickers’ Commission’s plan was seriously considered. Instead, in a well-meaning attempt to protect the American taxpayers from picking up the tab for Federally insured bank speculation, Congress adopted the so-called “Volcker Rule,” which prohibited Federally insured banks from engaging in proprietary trading. The trouble with that, as has been amply described in the financial press, is distinguishing between a bank’s “market making” and “hedging,” which are permitted under the law, and its proprietary trading, which is not.

Though the Dodd-Frank legislation with its “Volcker Rule” and its attendant complications will surely put a lot of lobbyists’ and lawyers’ sons and daughters through college and graduate school, my wish would be for Congress to take another look at the SIA Plan or the Vickers Plan or the Liikanen Plan, which are much simpler and cleaner and entirely non-partisan. Make no mistake, however, rather than the SIA Plan or Vickers’ or Liikanen’s, readopting Part II of the Glass-Steagall statute would be the ideal solution.

In July of 2013, Senators Elizabeth Warren, D-Mass, John McCain, R-Ariz, Maria Cantwell, D-Wash, and Angus King, Independent-Maine, introduced a non-partisan bill entitled the “21st Century Glass-Steagall Act of 2013” which would recreate and expand Part II of the original 1933 act. I heartily applaud the four senators for their concern for the American taxpayers and their courage in taking on the giant banks with their vast armies of highly compensated surrogates. Based on all my history on this issue, I couldn’t be more supportive philosophically of their efforts, I wish for their success and endorse the bill. However, sometimes the ideal solution might not be politically possible, and should their efforts come up short, I hope they will not give up and instead consider substituting the SIA plan, Vickers’, Liikanen’s or something similar, which might have a better chance of passage, especially since, in order for bank reform to work effectively on a global basis, there should be a measure of international cooperation.

In the fall of 2008 a Republican Administration and a Democratic Congress worked together in a bi-partisan manner to prevent the nation’s financial system from collapsing. They accomplished this by, among other actions, authorizing the U.S. Treasury and the Federal Reserve to inject capital into the largest banks. I believe that America and the world owe then Treasury Secretary Henry “Hank” Paulson, an enormous debt of gratitude for his role in leading our nation through the financial crisis of late 2008 and further, that the history books will look very favorably on the necessary and proactive actions he took at the time. (Full disclosure: Hank and I were fellow partners at Goldman Sachs for many years and remain good friends).

The capital injection from the government in 2008 was an absolutely necessary action that saved the financial system and most of the taxpayer funds advanced to the banks have since been returned to the Treasury with interest. Nevertheless, should the banks get into similar trouble again, the American taxpayers will not stand for another bailout by Congress. Therefore, the nation would have to rely on the uncertainty of the “Living Wills” section of the Dodd-Frank law to provide for orderly wind downs of failing Federally insured banks. But no one knows what would happen if the contagion from such failing banks were to spread rapidly throughout the system as it did in 2008. The result could well be financial Armageddon.

After my June 6, 2012 Washington talk, The Wall Street Journal published an edited version on their op-ed page on July 31, 2012. I received many positive responses to the piece, as well as to an interview I gave on Fox Business News on August 30, 2012. The op-ed and the interview can be found on the "Published Commentary" page of this site.

Also on that website is the full text of my 1990 interview with Investors Dealers’ Digest which describes the SIA Plan in considerable detail. Except for updating the plan to include references to derivatives, etc., I would change little today.

Subsequent to the publication of The Wall Street Journal op-ed, I have had productive meetings with Paul Volcker, former Chairman of the Federal Reserve (by telephone), Bill Dudley, President of the NY Fed, and Richard Fisher, former President of the Dallas Fed. Richard’s brilliant and authoritative articles, interviews and addresses have made the strongest possible case against the continuation of “Too Big To Fail.” (Note: Richard Fisher is not related to the aforementioned late Dick Fisher, who was the former revered CEO of Morgan Stanley).

Within the past few years, many prominent former chief executives of banks and securities firms have come to the same conclusion that I have, and believe that Congress should take action before it is too late.

Several other members or former members of the Federal Reserve have also publicly expressed great concern regarding the “Too Big To Fail” banks, in addition to Richard Fisher and Bill Dudley. They are, among others: James Bullard, President of the St. Louis Fed, Daniel Tarullo, Member of the Federal Reserve Board, Ben Bernanke, former Chairman of the Fed, Thomas Hoenig, former President of the Kansas City Fed and present Vice Chair of the FDIC and, most recently, Neel Kashkari, President of the Minneapolis Fed.

When I think of those Fed governors thoughtful public positions today, it troubles me since many of their predecessors at the Fed some 15-25 years ago must not have considered the consequences of their deregulatory actions and reached diametrically opposite positions from the enlightened views of the currentand former Fed board members noted above.

Though one must assume that the former Fed governors were acting in good faith and surely did not anticipate how severely their actions would contribute to the future weakening of our financial system and the risk to America’s taxpayers, in my view they should have given more deference to the authors of the Banking Act of 1933. After all, Messrs. Glass and Steagall and their colleagues had witnessed a financial debacle without precedent in our nation and, as I said at the start: “They knew what they were doing.”

Some might conclude that the enlightened views of the current Fed governors are a result of their being mugged by the reality of the financial meltdown of a few years ago, whereas the former Fed governors had no such distressing historical event to make them cautious about permitting Federally insured banks to speculate with taxpayer money. However, those former governors certainly had the stark example of the failure of the Savings and Loan industry in the 1980s and the $340 billion cost to American taxpayers, largely as a result of the expanded powers given by Congress to the S&Ls.

It’s comforting to finally have such prominent supporters as the former banking and investment banking CEOs in the prior table and the present and former Fed Governors mentioned above. Five years ago, to borrow Dartmouth’s motto, “Vox Clamantis in Deserto,” I was truly “a voice crying in the wilderness.” In fairness, though I had few allies over the last 20 plus years (for example, only eight out of 100 Senators voted against the repeal of Glass-Steagall in 1999), I was not entirely alone. Two of the most thoughtful and eloquent advocates of views similar to mine over the years have been leaders of the FDIC, Sheila Bair, former Chair and Thomas Hoenig, current Vice-Chair. Another very supportive voice has been that of George Will, the Pulitzer Prize winning columnist for The Washington Post and Newsweek.

A very encouraging legislative development is that in April of 2013 Senator Sherrod Brown, D-OH, and former Senator David Vitter, R-LA, introduced their comprehensive Brown-Vitter legislation which addresses the “Too Big To Fail” issue. Their bill requires that large banks hold substantially more capital than smaller institutions, and a lot more capital than current regulations and international banking standards require.

The supporters of that bill acknowledge that one purpose of the high capital requirements is to encourage such giant banks to downsize resulting in their no longer being considered “Too Big To Fail.” I certainly support the Brown-Vitter approach as does former Dallas Fed President Richard Fisher, and I hope it is successful since, until the 21st Century Glass-Steagall bill, it was the only approach on offer. However, the opposition from the “Too Big To Fail” banks, their lobbyists and lawyers has been ferocious. Those opponents argue that America’s largest banks would then be unable to compete effectively with giant banks from other nations. Of course that same argument was used a generation ago to convince banking regulators to weaken and Congress to repeal Part II of Glass-Steagall. They won that argument and the resulting chaos almost brought down the U.S. and the world’s financial system.

I am also encouraged that on July 9, 2013 the Federal banking regulators, led by the FDIC, and supported by the Federal Reserve and the Office of the Comptroller of the Currency, proposed stricter rules that would require giant banks to hold additional capital. It is certainly gratifying that such regulators, some of whose predecessors’ attitudes had been overly accommodative to the wishes of the regulated banks and whose deregulatory actions were instrumental in causing the nation’s acute financial problems, should now help lead the charge the other way.

I completely support The Wall Street Journal’s view which, like the Brown-Vitter bill, would require that giant banks hold significantly higher levels of capital to protect the American taxpayer. 

In spite of the message conveyed in this dinosaur cartoon, neither my approach nor Vickers’ nor the 21st Century Glass-Steagall bill requires downsizing (though the bank’s own stockholders may well conclude that downsizing is a wise approach); rather they require segregating the investment banking business from Federally insured commercial banking. I am not against bank size per se, so long as bank failure is permitted and Uncle Sam is off the hook. I am strongly against the corruption of capitalism which allows “Too Big To Fail” banks to exist.

As noted, the US taxpayer bailout of banks in 2008 was accomplished on a bipartisan basis with a Republican Administration and a Democratic Congress. Nine years earlier, in 1999, the repeal of the few remaining provisions of Glass-Steagall which separated investment banking from commercial banking was also done on a bipartisan basis. At that time there was a Democratic Administration and a Republican Congress. Thus I permit myself some guarded optimism by asking: why cannot the correction of that costly bipartisan error in 1999 and the avoidance of a potential financial Armageddon be accomplished in a bipartisan manner as well? While that aspiration may be too much to expect during an election year, 2017 is less than a year away.

If this critical topic has piqued your interest, and I certainly hope it has, I invite you to discover more perspectives and dialogue from former and current senators, congressmen, congresswomen, economists, academics, regulators and journalists throughout the Better Banking Law website.

Thank you and I welcome your comments and questions. Kindly connect with us at rndowney@betterbanking.com

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