Follow The Leader

What’s widely perceived as dithering at the Treasury over the resolution of doubts about the solvency of the US banking system may have more to do with preparations for regulatory overhaul. A far-reaching redesign of the national financial system is expected to begin in Congress in a few weeks and could be completed fairly swiftly.


Former Federal Reserve chairman Paul Volcker set the stage last week when he told a conference at New York University’s Stern School of Business, “Maybe we ought to have a kind of two-tier financial system.”  Volcker heads President Barack Obama’s Economic Recovery Advisory Board.  He broached the suggestion in a speech in Toronto a month ago.  This time it didn’t make the papers.


In fact the US had a two-tier system for more than 65 years, created by the Banking Act of 1933. The measure, which separated the commercial banking system from Wall Street investment banks and the insurance industry, became better known as the Glass-Steagall Act, after its sponsors, Sen. Carter Glass of Virginia (an architect of the Federal Reserve System and Treasury Secretary under Woodrow Wilson) and Rep. Henry Steagall of Alabama, chairman of the House Committee on Banking and Currency.


The Glass-Steagall Act passed quickly after the collapse of the banking system in 1933.  It created the Federal Deposit Insurance Corp. to insure bank deposits, and, in reaction to the speculative excesses of the1920s, sharply curtailed the risks that commercial banks were permitted to undertake. Underwriters and insurance companies, broadly considered to be engaged in commerce, were permitted greater latitude.


This traditional separation between banking and commerce was abandoned in 1999, after a couple of decades of financial innovation during which big companies invented their ways around most of the prohibitions, or obtained Congressional waivers until the law could be repealed. The Financial Services Modernization Act, sponsored by Sen. Phil Gramm (R-Texas), Rep. James Leach (R-Iowa) and Rep. Thomas Bliley (R-Virginia), created a unified banking system in which banks, underwriters and insurance companies were free to merge and compete.


President Bill Clinton signed the measure into law, a few months after being acquitted of impeachment charges, at the height of the boom.


The Gramm-Leach Bliley Act presumably will go into the history books as a spectacularly unsuccessful piece of regulation. Among its immediate side effects was the swift emergence of a vast “shadow banking system” of non-bank financial institutions, not the traditional non-bank lenders such as General Motors and General Electric, but hedge funds, monoline insurers, money funds, conduits and structured investment vehicles (SIVs), so lightly regulated as to be able to achieve astounding capital-to-debt ratios through the use of exotic financial derivative instruments.


It was the commingling of this shadow system with the financial system itself that turned a financial crisis into a worldwide economic recession – a sequence of events not seen since the early 1930s.

Much skepticism is voiced these days about the presence in the administration of Lawrence Summers, National Economic Council chairman, who oversaw much of the preparation for financial deregulation as Deputy Secretary and then Secretary of the Clinton Treasury Department, and of his former deputy, Timothy Geithner, now serving as Treasury Secretary himself. Both men rose to prominence under the tutelage of Treasury Secretary Robert Rubin, onetime co-chairman of Goldman Sachs, and senior counselor to Citicorp in the years after leaving office.


Summers is a man of ultimately independent mien. The president has described him as a “thought leader” within the administration And Simon Johnson, of the Massachusetts Institute of Technology, has observed that the poacher-turned-gamekeeper has played an honorable role in the long history of regulation. (After resigning the presidency of Harvard University, Summers became a managing director of D.E. Shaw, a hedge fund and private equity firm with headquarters in New York.)


But Volcker, a legendary figure in global financial markets (and an early Obama supporter at a time when Rubin, at least, was still backing the candidacy of Hillary Clinton), is probably the one to watch, even though he is 82 and holds no statutory office. Congressional re-regulation of the financial system could be as effective as antitrust measures in breaking up institutions heretofore deemed “too big to fail.” Separating the deposit base from the underwriting and trading activities of financial firms would go a long way towards enabling government and competitive forces to sort out the problem of these “toxic assets.”


None of this is based on inside knowledge. It’s an educated guess, based on legislative history, a sense of the extent of public anger with financial firms, the mood of the Congress, and some knowledge of the personalities involved. Expect the administration’s ultimate goals to become clearer in the next few weeks, especially if Congress begins to force its hand. As the old witticism has it, Time is God’s way of keeping everything from happening at once.