Super Glass-Steagall

Super Glass-Steagall
November 28, 2010

At some point, governments will probably have to give up the extend-and-pretend and instead actually try to solve the problems they are faced with. Then, ideally, they will take a few steps to make sure these problems don’t happen again in the future.

A constant problem with banking systems in general is their “systemic” nature. The failure of a bank, or a series of large banks, causes problems far beyond the bank itself. For example, if a corporation has $10m in a bank account, and that bank goes bust, then the corporation might be unable to make debt payments or pay its employees. This could cause the corporation to go bust even if it was in fine financial condition.

Before the 1930s, banks were largely unregulated. As hundreds went bust in the 1930s, a series of new regulations were imposed to prevent “systemic” issues from recurring. One of these was deposit insurance, for small savers. In those days, the only “savings” option open for many individuals was bank savings accounts. They didn’t have money market funds (a 1970s innovation). Stock market “trusts” had a tendency to be rather risky, and often used leverage. (As a result of huge losses in leveraged trusts, mutual funds were required henceforth to use no leverage.)

Among these innovations was the Glass-Steagall separation between commercial banks and investment banks/broker-dealers/merchant banks etc. It was, I would say, one of the very few examples of an almost perfect piece of regulation, which accomplished its goals while introducing few meaningful new problems.

Wikipedia on Glass-Steagall

The idea was: we didn’t want a commercial depository bank, insured by the FDIC (created by Glass-Steagall), to be subject to losses coming from investment bank shenanigans such as derivatives and so forth. The idea was to make the “systemic” part of the financial system, the commercial depository banks, relatively safe. The risky, unregulated bits would be shunted off to the “investment banks,” which could go bust and be liquidated without much “systemic” consequences.¬†Glass-Steagall was effectively repealed in 1999, and we’ve seen the explosion of financial nonsense that has taken place since then.

The reason for the repeal of Glass-Steagall was to create greater profits for bankers. Where do profits for bankers come from? It is basically a function of leverage combined with the spread or return on assets. Even in the case of complex financial games as played by the investment banks, this is more or less the case.

March 23, 2008: How Banks Work 7: the Lender of Last Resort
March 9, 2008: How Banks Work 5: Selling Loans
February 24, 2008: How Banks Work 4: Banks and the Economy
February 17, 2008: How Banks Work 3: More Elephant Poop
February 10, 2008: How Banks Work 2: Shitting Like an Elephant
February 3, 2008: How Banks Work
To generalize, I would say that the extra profits from the repeal of Glass-Steagall came about because investment banks were able to use the commerical banks’ balance sheet, because they had been combined into one. How does this work? Remember that the commercial banks were “depository institutions,” which meant that they had relatively cheap funding from depositors, in no small part because of the government guarantee. Also, they were considered “too big to fail,” more or less, so they would be rescued in the event of disaster, as indeed turned out to be the case. So, the banks’ non-deposit funding, i.e. bank debt, also could be issued relatively cheaply. Thus, the cheap funding led to a greater spread and higher return, not only on plain-vanilla commercial and consumer lending, but also the whamma-jamma investment bank stuff going on. Remember, investment banks under Glass-Steagall had been segregated as the risky, disaster-prone part of the industry. So, their funding (debt) would normally carry a higher interest rate.

The second part of the equation is leverage. Although commercial banks generally adhered to various captial ratios that were supposed to limit leverage (although even they weren’t all that restrictive), when they added on their investment banking operations, and also various off-balance-sheet liabilities which became popular, in effect they were taking waaaay more risk with their capital base, which in effect means more leverage.

The result was systemic kerflooey, exactly what Glass-Steagall had been designed to prevent.

As you might expect, this makes me a fan of Glass-Steagall. But could it be improved? After all that has happened, since 1933 and especially in the last few years, you’d think we could do an even better job today.

I thus propose “Super Glass Steagall.” What would it contain?

1) Commercial, depository banks are once again segregated from “investment banks.” This means no derivatives dealing, securities issuance, and so forth. Nothing on the asset side except loans and publicly-traded bonds. Nothing on the liabilities side except for deposits, straight debt, and maybe some preferred equity. No off-balance-sheet liabilities, SIVs, and other such nonsense. Capital ratios apply. Accounts below $250,000 are insured by the FDIC, as is the case today. Commercial deposits are not insured, but are senior to bank debt. Derivatives can be used, but only in bona-fide hedging of existing, on-balance sheet assets (i.e. loans).

Here’s the new bit: at least 30% of the bank’s liabilities must consist of bank debt, not deposits. Next, this debt falls under government regulation so that it can be converted to equity at any time, according to the judgement of the banking regulator. In effect, a “prepack bankruptcy” under regulator oversight is built into the debt from issuance. (Because it is written into the debt from the start, it would not actually be a “bankruptcy.” “Bankruptcy” refers to the failure to perform on obligations.) Lastly, all other financial obligations and existing equity are junior to the bank debt, so they are rendered worthless in the event of a debt conversion. This would also be “written into the contract” from the beginning, such that a regulator-led debt conversion/recapitalization won’t cause a “failure to perform.”

This would make bank recapitalization very easy. You just “press the button,” and the bank’s debt would magically convert to equity, thus recapitalizing the bank with no legal hassles. Since this bank debt carries the risk of regulator equity conversion, they would probably have a somewhat higher yield. The regulator could also opt for a partial conversion if that seemed best, for example converting half of the bank debt to equity and leaving the remainer as debt.

October 12, 2008: Effective Bank Recapitalization 2: Three Examples

2) Investment banks/broker-dealers are free to live and die on their own. Their own funding (debt) would reflect the risk of failure, and carry a higher interest rate, as it should. Capital limits should apply, however.

3) However, there should be a third class of financial institution, which is in effect a securities depository institution. This is a prime broker (for institutional accounts), and also custodial brokers such as Ameritrade and other such companies used by individuals. Bankruptcy of an investment bank also carries “systemic” risk for those who use these institutions for custody, which is practically everyone today. Custodial arrangement should be separated from IB/BD balance sheets. For example, when Lehman Brothers went kerflooey, anyone using Lehman as a prime broker ended up in bankruptcy court hoping that they would receive their securities from the bankruptcy judge. I bet that was a lot of fun.

Gibbons: When a Prime Broker Fails: Critical Issues from Fund Managers in the Lehman Bankruptcy

Close to 100 hedge funds used Lehman as their prime broker and relied largely on the firm for financing. In an attempt to meet their own credit needs, Lehman Brothers International routinely re-hypothecated[30] the assets of their hedge funds clients that utilized their prime brokerage services. Lehman Brothers International held close to 40 billion dollars of clients assets when it filed for Chapter 11 Bankruptcy. Of this, 22 billion had been re-hypothecated.[31] As administrators took charge of the London business and the U.S. holding company filed for bankruptcy, positions held by those hedge funds at Lehman were frozen. As a result the hedge funds are being forced to de-lever and sit on large cash balances inhibiting chances at further growth.[32] This in turn created further market dislocation and over all systemic risk, resulting in a 737 billion dollar decline in collateral outstanding in the securities lending market.[33]

Wikipedia on the Lehman Bankruptcy

These custodial/depository brokerages can offer brokerage servcies for customers, but should be banned from holding any securities that are not owned by their customers. In other words, no dealing, no proprietary trading, no HFT, etc. etc. Also, they would engage in no other investment banking operations, such as securities issuance, derivatives dealing, etc. In effect, they would become a lot like existing execution brokerages for retail accounts, like Ameritrade or Interactive Brokers. First, this segregation removes the risk of IB/BD implosion from affecting the status of securities holders. Second, as order-takers and also custodians, these companies have information that could easily be used (and in fact is used every day) to trade against their clients, in the form of front-running and also various strategies designed to force liquidation of holdings, causing customer losses. These custodian/broker companies should have some limits to leverage, which in this case would be mostly margin leverage. Investors can use more leverage if they like, but it should be through some external institution, not the custodian itself. IB/BDs can still take customer orders, but would be banned from a prime brokerage/custodian role.

So, what does the financial system look like after this? First, you have the commercial, depository banks, the most “systemic” part. These are safe, safe, safe, because they don’t have investment banks to get them into trouble, they don’t have off-balance sheet liabilities, derivatives and other hidden leverage, and if they get into trouble, there is an instant “fix the problem” option for regulators by way of the debt/equity conversion.

Second, you have the securities custodian/broker, which is also rather safe. It has limited leverage (margin lending), and has no operations besides holding securities and taking trade execution orders. Safe, safe, safe.

Lastly, you have all the risky bits put into the IB/BDs such as Goldman Sachs. What would they do? They would have their various dealing operations, derivatives (maybe derivatives should be shunted into their own corporate structure), securities issuance and investment banking. What would happen if an institution like this went bust? First, their lenders would take a loss, but they should have known what they were in for. This would have no systemic effects. Anyone using them as a derivatives counterparty would take a loss, but that is also part of the game from the get-go, with little systemic consequences. Lastly, their investment banking/securities issuance operations would cease, but there are many, many companies offering these services, so any compnay that needed to raise capital could go to another firm. In fact. the very same people in the failed firm would soon show up in another firm, so in effect all that would change is the name on the business cards. In other words, these sorts of companies could go bust with no particular consequences.

Most people today are drooling morons when it comes to understanding how currencies work, and basic economic management. However, they are very good at this sort of legal/regulatory stuff. So, I would say that it is fairly likely that some sort of solution like this could be implemented, at least by the more enlightened governments.