The Volcker Rule and the Curse of the Second Best Solution (Part 2)

The premise of the last post was that the Volcker Rule is a second best solution designed to reduce the risk that a bank too big to fail will in fact fail.  The alternative approach would be to make the banks smaller so that they were not too big to fail.  One way to do this would be to strengthen the Volcker Rule into something that more closely resembled the barriers imposed by Glass Steagall.  The effect would be to downsize the large banks through additional limitations on their activities.  In effect, it would result in smaller financial institutions without imposing specific size limitations.  

At the same time, the division would allow the development of a group of investment banks that could provide additional competition in the financial markets.  Recall that before the recent financial crisis, there were five large investment banks (Goldman, Morgan Stanley, Merrill, Bear Sterns, and Lehman).  They competed with commercial banks by offering capital raising expertise.  Two of the five were acquired (Bear and Merrill), one failed (Lehman) and two converted to commercial banks.  The large free standing investment banks have been eliminated. 

The idea of a reinstatement of Glass Steagall has been mentioned often but has generated little serious effort.  So it was quite interesting to hear an unexpected source call for the reinstatement of Glass Steagall, Sandy Weill.  Weill, probably more than any single industry titan, was responsible for the elimination of Glass Steagall.  He presided over the financial conglomerate that consisted of a combined Travelers and Citigroup. 

According to the WSJ, he was reported as saying: 

  • What we should probably do is go and split up investment banking from banking, have banks be deposit takers, have banks make commercial loans and real estate loans, have banks do something that’s not going to risk the taxpayer dollars, that’s not too big to fail

The statement is not unlike the about face taken by Alan Greenspan during the financial crisis.  It is a recognition that prudential limitations (Glass Steagall) may sometimes be better than piecemeal and complicated regulatory structures (the Volcker Rule).

For an article on the benefits to the capital markets of having a Glass Steagall type restriction in place, see The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.

J Robert Brown Jr.