Restore Glass-Steagall? Most of It Was Never Repealed

As policymakers respond to FDIC Vice-Chairman Hoenig’s call for a "healthy debate" about the "21st Century Glass-Steagall Act" introduced by Senators Elizabeth Warren and John McCain, they need to start with an accurate understanding of just what the Glass-Steagall Act provided and how subjects covered by the new bill have already been treated by the Dodd-Frank Act.

Two key distinctions are essential to an evaluation of Warren-McCain. The first is the difference between activities conducted by an FDIC-insured commercial bank, on the one hand, and activities conducted by a nonbank uninsured affiliate of that bank, on the other. The second is the difference between an activity in which an institution acts as principal, i.e. places its own capital at risk, and an activity in which it simply acts as an agent for a customer. These distinctions are critical to an evaluation of how "risky" an activity is to the financial system.   

On the first distinction, Warren-McCain would apply its prohibitions on activities to both the insured bank and to all of its affiliates. As to the second, the banned activities include activities in which the entity acts as principal: underwriting, dealing in, and the proprietary trading of financial instruments. In a relatively novel approach, however, the ban would also extend to traditional agency activities: brokering transactions for the account of customers and providing investment advice about securities. In an apparent concession to the relatively benign nature of these latter, agency activities, the bill would allow insured banks themselves to continue to provide investment advice and brokerage services for customers of their trust departments.

How do these proposals compare with current law?

First, contrary to repeated assertions by financial journalists and politicians, the Glass-Steagall Act was never "repealed." The most important part of the statute remains on the books. The Act contained two principal prohibitions: a ban on the ability of a bank to underwrite and deal in most securities and a ban on the ability of a bank to affiliate with a company that is principally engaged in the business of underwriting and dealing in those securities. The second of these prohibitions was removed by the 1999 Gramm-Leach-Bliley Act; a bank holding company is now free to own both a bank and an investment bank that is engaged principally in underwriting and dealing in securities. However, the first of these prohibitions remains.  A bank – the entity that most directly benefits from taxpayer support through deposit insurance – may still not engage in these activities.

Second, proprietary trading is prohibited by the 2010 Dodd-Frank Act under the so-called Volcker Rule. The prohibition on proprietary trading applies to all subsidiaries of a bank holding company, including the insured bank and any investment bank subsidiary. Whereas Glass-Steagall’s prohibitions applied only to securities, the Volcker Rule’s prohibition applies to securities, futures contracts, and derivatives. Notably, the Volcker Rule includes an exception for any underwriting or dealing activities.   

Third, under current law, an insured bank is already largely immunized from whatever risk is associated with securities brokerage and with swap transactions. With certain exceptions, an insured bank is effectively prohibited from engaging in securities brokerage by the so-called "push-out" provisions of the Gramm-Leach Bliley Act. Comparable "push-out" provisions of the Dodd-Frank Act prevent a bank itself from engaging in most swaps activities.

Finally, the Volcker Rule severely curtails the ability of a bank or any of its affiliates to sponsor a hedge or private equity fund. The rule permits a bank or an affiliate to provide investment advice to investment funds; however, if the bank or affiliate is not also the sponsor of the fund, the commercial opportunity and appeal associated with doing so is limited.

In short, current law largely prohibits an insured bank itself from engaging in all of the activities that Warren-McCain seeks to ban and prohibits a bank’s affiliates from engaging in proprietary trading.  What’s left? Warren-McCain boils down to three prohibitions imposed on any nonbank affiliate of a bank: one on underwriting or dealing in securities (the reinstatement of the "repealed" portion of Glass-Steagall); one on brokering transactions for the account of customers; and one on giving customers advice about the merits of investing in securities.

The arguments on the first of these prohibitions are familiar. Some think that underwriting and dealing in securities in an investment bank pose a risk to the insured bank under the same roof. On the other hand, Sen. Warren herself has said the prohibition probably would not have prevented the financial crisis. Paul Volcker made a point of denying that his rule was intended to prohibit affiliates of banks from underwriting and dealing in securities and provided an exemption from his rule to ensure this result. Others have observed that, without the partial repeal, the private rescues of Bear Stearns and Merrill Lynch would not have been possible.

That leaves brokerage and investment advice, agency activities conducted outside the insured bank. The sponsors of Warren-McCain apparently think that these activities are so risky that they threaten the stability of the financial institution of which they are a part.  If this is so, why does their bill permit an insured bank to continue to engage in these activities within the bank? 

To be sure, the exceptions to the prohibitions in current law, many of which Warren-McCain would eliminate, can be critical. Nevertheless, Warren-McCain demonstrates the importance of analyzing where within a bank holding company the banned activities would be conducted and the precise nature of each activity that would be banned. When that analysis is concluded, it may well be that there is less to Warren McCain than their sponsors would have us believe.

Winthrop Brown is an adjunct professor at Johns Hopkins University School of Advanced International Studies. Until March, he was head of the financial institutions regulatory practice at Milbank, Tweed, Hadley & McCloy LLP.