A decade after Glass-Steagall's repeal, it's time to reverse Sandy Weill's legacy
Filed under: Citigroup, Travelers
The Glass-Steagall Act -- a law passed in 1933 that separated investment banking from commercial banking with the aim of preventing another Great Depression -- was repealed exactly 10 years ago today at the urging of Sandy Weill so that Citicorp and Travelers (TRV) could merge and from Citigroup (C).
Weill, at the time the CEO of Citicorp, got then-Treasury Secretary Robert Rubin's support for what turned out to be a disastrous regulatory change, one that was finally passed as Rubin passed the baton to his successor -- Larry Summers (now director of President Obama's National Economic Council). That's because the repeal freed Citi to combine commercial, consumer and investment banking into a one-stop shop -- and created a recipe for financial disaster.
How so? First, the merger was bad for Citi shareholders -- largely because Weill's one-stop-shop concept failed with consumers and with the merged pieces. Now, Citi's recent near-death experience has left taxpayers on the hook for $306 billion. And were it not for the passage of the Gramm-Leach-Bliley Act, which repealed Glass-Steagall in 1999, it's quite possible that our current financial crisis would not have happened.
How so? Citi's growth to the point where it was too big to fail (or even manage) was a direct result of repealing Glass-Steagall. Although Citi wasn't the only bank that the federal government decided to prop up during the current crisis, it certainly was the biggest and most costly for taxpayers. Yet were it not for the combined wills of Weill and Rubin, we might not be in the mess we're in now.
What the federal government ought to do now is restructure the architecture of finance. Banking should be returned to a supporting function in which it can no longer take actions that put the entire global economy at risk. What would it take to do that? As I have previously posted, six reforms should be put in place.
If those reforms pass into law, I have promised that I would dance a hula on Wall Street. But since I believe that Wall Street has effectively purchased the Treasury Secretary's office, I don't expect to find myself gyrating in a grass skirt anytime soon.
But likely or not, here are the six ways I think we need to re-architect finance:
End securitization. If financial engineers can find a way to bundle loans into securities that are guaranteed not to lose money for investors, then securitization should continue. The collapse of the market for mortgage-backed securities and collateralized debt obligations demonstrates that achieving this could be nearly impossible.
If there's a way to reconstitute the benefits of securitization -- namely, lower interest rates for borrowers -- without the costs we're now incurring, then it might make sense to continue the practice. Otherwise, end it for good.
Lower leverage. We should closely monitor all actors in the financial system -- including banks, hedge funds, insurance companies, businesses and households -- to set clear targets for maximum leverage and to ensure that none of them is able to exceed those targets. More important, we need to create a culture of savings and living within one's means to extinguish the urge to borrow and spend more than one can repay.
Enforce transparency. Trust in the financial system depends on timely, accurate and complete information. Such information should extend across all kinds of financial transactions -- providing investors with the ability to assess the financial strength and future prospects of the companies in which they invest; giving companies knowledge of the soundness of their partners, suppliers and customers; and providing consumers a true picture of the honesty -- or lack thereof -- of their lenders and brokers.
In the year since I made that suggestion, the Madoff scandal has revealed that we're still suffering the effects of letting managers write their own report cards. No progress has been made on freeing us from that systemic flaw.
Create morally defensible incentives. As I've posted, bankers and other participants in the financial system get paid to bring in big volumes of business. Their bonuses are calculated as a percentage of the size of their deals. If investors later lose their investments in those deals, the bankers get to keep their money. To fix this problem, I would require them to keep their bonuses in an escrow account.
If after, say, five years, that investment were still valuable, the banker would receive the money out of escrow. Otherwise, the escrow would pay the losses that the investor incurred from the bad deal. This kind of structure could reduce the moral hazard in the current incentive system by encouraging bankers to book deals likely to make money for investors.
Build global firewalls for derivatives. Designers of our new financial system needed to establish ways to keep the problems of one institution from bringing down others -- whether in the U.S. or in other parts of the world. For instance, AIG's collapse could have damaged many of its interconnected credit default swaps counterparties. However, that problem would not have arisen if there had been an independent exchange for trading CDS.
Break up companies deemed too big to fail. I believe that there's a limit to how big financial institutions should get. When they exceed that size, the government should require them to break up into smaller pieces. The reason is that we shouldn't be rewarding managers for building big companies that can't earn profits that exceed their cost of capital. And we should not require taxpayers to pay for the cost of such failure.
At this point, the financial system has become far too complicated to go back to the days where simply separating investment and commercial banking could prevent financial Armageddon. But we certainly need to return to the spirit in which Glass-Steagall was passed back in 1933 -- the desire to keep Wall Street from ruining the world.
These six principles would help us get there.
Peter Cohan is a management consultant, Babson professor and author of nine books, including Capital Rising (due in June 2010). Follow him on Twitter. He owns Citi and Travelers shares.
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Reader Comments (Page 1 of 1)
11-18-2009 @ 2:46PM
BrianSherwood said...
Excellent article. I agree 100% with it.
President Obama, you have the wrong man; Peter Cohan should replace Larry Summers!
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11-12-2009 @ 9:38AM
m e katz said...
Absolutely correct on every point. We need to separate investment banking from savings. We need to get back to the idea of bankers actuallly knowing their customers, and lending on the basis of character (which means ability & willingnesss to pay.) The focus on lending must return to the ability to pay--instead of the valueof the asset.
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Securitization may be advantageous, because it can make more money available to be loaned out.
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It's obvious that transparancy must be insisted upon in all areas of finance.
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I like the authors idea of escrowing bonuses, and using them to make purchasers of "bad" mortgages whole.
Michael E Katz --Katz8356@comcast.net
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11-12-2009 @ 9:45AM
cabo79 said...
Good luck. I think financial salesman from loan officer on up should be straight salary ONLY.
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11-12-2009 @ 10:15AM
JD said...
Okay Peter Cohan, we are in agreement EXCEPT - insurance companies SHOULD NOT be in the securities/stock/investment banking business at all, period. Their business is insurance, which is premium payments collected from their customers whose sole purpose should be to INSURE! It is not now, and never was money that can be used to gamble with. The insurance business from its inception has been a cash cow. The biggest buildings in every major city have insurance providers names on them. The insurance industries greed and lust for more and more money, their executive compensation packages, their extravagant lobbying expenses, and their fingers in far too many high risk financial pies, is unnecessary, and for many decades it WAS illegal. Let the risk takers - take the risks in the markets. Insurance premiums need to apply to insurance policies. No part of that premium should be used to gamle with - or - own companies that gamble for a living. Trust me they'll still make truckloads of money, they always have.
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11-12-2009 @ 9:53AM
Bob said...
It is about time that banks give investors a fair shake. There is no place for the average investor to stay ahead of inflation or even keep up with it. There are millions of baby boomers who can't make a dime for retirement. In some of the possible options they only have the stock market. The Market ( Poker game) is totally controlled by the big traders, goverment and the banks. My family has been here since the beginning of this once great country, served in all wars even the Battle of the little Big Horn. My taxes now go to support slaves that I can't even afford. My bones are broken, life shattered and virtually insane. All I hoped for was an even shake with hard work and honesty...no way huh? Looks like we are doing the same thing all over just to get the market back up. Someone will get rich
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11-12-2009 @ 11:11AM
ajgorm said...
This is like letting the caT out of the bag then trying to force it back in. The fact remains we must allow the American dream to branch out to the poor at lower class prices they can afford. How do we do this. OHhh Freddie and fannie okkk but then what sell the paper abroad and create phony loan docs while claiming inflation is the fix to poor credit and dreaming about endless supply of jobs. If only they knew what peak meant. ..fools dream. Subsidized government housing GET WITH IT. Dont create sub prime loans and release them into the over all banking system to sell abroad end that prctice and form a pool or fund they pay into and the treasury and governemnet regulate its function. Regulate low income home building and limit the number you build yearly till we have a good supply and yearly demand that is sustainable..
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11-12-2009 @ 11:20AM
Bob B said...
If you go back to life before Sandy.... John Read (a recent apoligist for the mess that has become of the banking industry), was running Citi. John, a trained engineer placed the utmost importance in developing and maintaining operation controls within Citibank. He invested in ensuring the staff was properly trained and knew how to manage and minimize both operational but financial risk... then Sandy arrives.... it becomes all about "the deal". It didn't matter how things on the inside worked as long as you could cobble together the pieces of a machine that offered anything and everything to all "customers", it really didn't matter how well internal operations would run. The partnership between Citibank and Travels was never a partnership, Sandy quickly outgunned John Read as a slick saleman will tend to do when put up against an operations guy. The internal training was shut down, operations management was no long considered worthy of Sandy's attention... it was all about what "deal" we could pull off next. So fast forward, Sandy leaves Citigroup with a huge departure package having raped, pillaged and plundered the stakeholders during his reign of terror.... but once the deals stop... the music stops.... there are no more chairs for the stakeholders to sit, except for Sandy who still has not realized the holistic long term consequence of his actions... he made off with the treasure, can donate it to effect his own public policy, while the rest of the stakeholders: employees, taxpayers, peer institutions all try to pick up the pieces. John Read, you're an honorable man. Thank you.
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11-12-2009 @ 11:32AM
Harley said...
If they are too big to fail; shrink them.
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11-12-2009 @ 11:42AM
ajgorm said...
Pay for the war dereguate housing free up credit we have had slow growth we need to speed things up. This was the drum beat of the nineties they let the gates down on regulation and now they need to put them back up they drained the liquidity out of oranges and now are using ROCKS. SIMPLE. But then our debt will be a noose but at least we will be on a path we can eventually sustain..much better idea than the socialization panic stricken Geitner and Obama and the NWO have been using..
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11-12-2009 @ 11:46AM
Rene said...
Another example of scuttling regulations to accomodate lobbyists - just like removing the "uptick rule" in ~1997!
Tha bad news is: the same "advisors" are still around.
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11-12-2009 @ 5:27PM
Russ said...
I agree Rene the old Clinton Gang... Summers,&Rubin messed things up and they have imput to the Obama Gang which is clueless! The dollar is doomed and so is our economic health! But the media could care less!
11-12-2009 @ 11:51AM
ajgorm said...
OHHH Nooo what will they do without more PORK to spend ? Go back to the eighties...GOOD IDEA !
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11-12-2009 @ 12:21PM
Van Turkington said...
Well stated!
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11-12-2009 @ 12:33PM
ajgorm said...
Bush could have repealed it.. Obama can repeal it but noone seems to know it still exists. Or is it that the mess can not be fixed making it a TOXIC situation.
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11-12-2009 @ 2:09PM
Jim said...
Professor Cohan is right. We do need reform, although I'm not sure that returning banks to a "supporting function" is the way to go. Globalization and the information revolution have made the good ol' days where banking existed in one box and securitization in another -- the Glass-Steagall model -- impossible. Cohan pretty much admits that in his final paragraph. Let's not throw the baby out with the bath. I don't think we should prohibit securitization, the benefits are too great. And I think we should keep a small area beyond the regulator's reach. Nothing like the 60 percent of lending that runs outside the old-line banking system (twice what it was 20 years ago) but just enough to encourage inovation. The information revolution still has a way to go, and the biological revolution has just begun. Old-line bankers are not the people to finance revolutions.
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11-12-2009 @ 3:01PM
Al said...
Yes, indeed, your six principles would help. Any principles would help, but, this world is divided into people who play with other people's money and the rest of us. Any, and all, laws are an all-USA solution - to a slightly larger problem. As long as this planet is divided against itself, real investors do whatever they please, limited only by the laws - of physics. But, uniting to one world government would simplify the distribution of bribes - first, and very possibly, only. I am an old man. Young people pretending they can make a difference is nice. Stupid, but, nice :)
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11-13-2009 @ 12:29PM
Michael Siteman said...
Peter has done an excellent job of elucidating the catastrophic results of repealing the Glass-Steagall Act as well as recommending the steps that need to be taken now to restore sanity and trust in the financial community and the economy. I hope that someone in the regulatory circles of the government is reading and listening, though from what I've witnessed thus far, the only people to whom the Treasury Secretary, Fed Chairman, President, Senators and Representatives are listening are those on Wall Street.
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