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Bring Back That Wall!

Would a new bill bringing back Glass-Steagall prevent another banking meltdown? Nomi Prins on why change is urgently needed.

12.16.09 7:22 AM ET

The Obama administration is talking tough but acting tame with respect to Wall Street. But a pair of senators is coming out swinging. Today, Senators Maria Cantwell (D-WA) and John McCain (R-AZ) are taking a step towards proactive reconstruction of the banking sector by introducing the Banking Integrity Act of 2009. The bill would reinstate provisions of the Glass-Steagall Act of 1933, the New Deal-era law that built a wall between commercial banks and risky investment banking.

“Federally insured deposits must not be used as fuel for the fire of speculative trading at the expense of lending or investing,” Cantwell said. The Washington state Democrat has been particularly focused on banks’ excessive use of capital for derivatives transactions and is working hard to reduce the risky nature of today’s derivatives environment. “Exactly how much capital that could be used for solid investing has been shifted towards derivatives instead?” Cantwell asks, going straight at one of the most complex issues with the current banking landscape.

“Federally insured deposits must not be used as fuel for the fire of speculative trading at the expense of lending or investing,” Cantwell says.

Unfortunately, it’s not so easy to track capital in that manner (though I wish it was). Banks don’t report the exact details of how capital gets allocated beneath each of their various derivatives or other types of trading businesses. But, with a solid focus on detail and content, Senator Cantwell, a former RealNetworks executive, will get to the bottom of it. As the big banks have grown bigger and more complex, their appetite for risk has also escalated. The trading revenues for the big banks have dramatically increased. Indeed, trading profits at the top five banks jumped from a loss of $608 million in 2008 to $119 billion for annualized 2009 (compared to $62 billion for 2007.) That kind of sheer fluctuation in itself introduces systemic risk.

At the same time, big banks are not using their capital for lending—part of Sen. Cantwell’s concern. Lending has declined. Total loan and lease balances fell by $210.4 billion (2.8%) last quarter, the largest percentage decline in any quarter since banks started reporting the figures to the FDIC in 1984. This gives a strong indication as to where banks are putting, and not putting, their capital. Trading is fine. Lending not so much. And given the current structure of the banking landscape, this is the preferred business plan. Specifically, the Banking Integrity Act would separate commercial (depository) and investment banking companies. No member bank (read: any bank that gets federal support of any kind) could be merged with any other firm that creates or trades securities.

The act would forbid investment bank employees from serving on the board—or in any senior capacity, for that matter—at a member bank. And the legislation would prohibit depository institutions from engaging in any kind of insurance business (including reinsurance—and that means you, AIG).

The result? A reduction in systemic risk and greater transparency. An end to the idea that a bank could become too big to fail. Mega-bank bailout recipients (such as Goldman Sachs, Morgan Stanley, Citigroup, JP Morgan Chase and Wells Fargo) would have to spin off their investment and insurance operations from their depository, commercial banking operations. Or, they could choose to exit the public tent altogether, and say good-bye to government life-lines when they screw up (or mega-bonuses the very next year—and that means you, Goldman Sachs).

Sen. Bernard Sanders (I-VT) certainly paved the way for Cantwell and McCain last month, when he introduced his ”Too Big To Fail, Too Big to Exist" bill. But so far, neither the recently passed House financial reform bill nor the one that Senate Banking Committee Chairman Christopher Dodd (D-CT) introduced, proactively separate commercial from investment banking.

Now, once you get past the bank language of the Act, this is a pretty interesting political development. Will more Democrat senators rally around Cantwell? Sanders bill is good, so far it hasn't been taken up publicly by many senators. She is certainly one of the most financially savvy senators around. And she’ll likely pick up support from colleagues—like Sen. Byron Dorgan (D-ND)—who have been opposed to the repeal of Glass-Steagall since it happened in 1999.

On the Republican side of the aisle, will the GOP do the maverick thing—and take this as an opportunity to turn the screws on Obama? McCain would be calling the president out, by instilling reform that Obama only talks about. McCain did not vote for or against the repeal of Glass-Steagall in 1999 (though one of the early economic advisors to his 2008 presidential campaign, Phil Gramm, was an architect of the Gramm-Leach-Bliley Act that brought down the wall dividing risk-taking from consumer-oriented banking firms).

Obama’s chief economic advisor, Larry Summers and Treasury Secretary Tim Geithner have been spectacularly reticent about resurrecting Glass- Steagall. They would adopt stricter capital holding rules for the mega-banks and better resolution processes to deal with future failures, rather than take a hard-line approach to separate banks before that becomes necessary.

Given the administration’s resistance thus far to the idea of reinstating Glass- Steagall, and the stalwart bank lobby that loves “big,” does this bill stand a chance? I sure hope so. I’ve been writing and talking about a modern day Glass-Steagall since I quit Goldman Sachs, many trillions of bailout and subsidization dollars ago.

Plus, stranger things have happened. The original Glass-Steagall Act was passed with solid bipartisan backing. Democratic President Franklin Delano Roosevelt summoned his friend William H. Woodin, a Republican businessman who served as FDR’s Treasury secretary, to help. Just like Treasury Secretary, Tim Geithner, Woodin came to the post from the Federal Reserve Bank of New York. Unlike Geithner, Woodin was committed to preventing, rather than mitigating, future attacks on national financial stability by Wall Street. The act was signed into law on June 15, 1933, in the middle of the ongoing Pecora Commission hearings that dug into Wall Street’s most reckless, economy- destroying practices. The SEC was created to enforce the rules of the Securities Act of 1933. And the FDIC was created to insure deposits against banks using them as chips on a dangerous speculative betting table. That’s sweeping reform.

Over the decades, the financial sector, armed with strategic lobbyists and overpaid lawyers, took many swipes at Glass-Steagall, finishing it off with the Gramm-Leach-Bliley Act—which not only repealed the 1933 law but also the best of the Bank Holding Company Act of 1956. The Gramm-Leach-Bliley Act allowed the merging of insurance, commercial banking and investment banking firms, all under the bank-holding company umbrella.

Since then, the banking sector has undergone waves of massive consolidation. All these new mega banks churned deposits and loans into debt or capital to fund speculation—also known as risk.

They created a roller coaster of an economy defined simply by whether their bets, or asset creations, worked or not, at any given moment. When the bets went bad, as happened last fall, the government stepped in. In the year since, government-supported banks have substantially increased their trading, or most speculative activities, to make up for their lack of lending.

A reinstatement of Glass-Steagal would force banks to pick a side not have it both ways. The public wouldn’t be subsidizing Wall Street’s risk or bonuses. Wall Street investment banks (no matter what name they were called last year) would get to return to the free market—where you keep your wins and suffer your losses. And commercial banks would get reacquainted with their client base. You can just hear Jimmy Stewart smiling. Whatever happens, the discussion’s about to get good. I think we’ll be debating the return of Glass Steagal at a whole new level now.

Nomi Prins is author of It Takes a Pillage: Behind the Bonuses, Bailouts, and Backroom Deals from Washington to Wall Street (Wiley, September, 2009). Before becoming a journalist, she worked on Wall Street as a managing director at Goldman Sachs, and running the international analytics group at Bear Stearns in London.