Megabanks and the Need for Glass Steagall

Politico has a piece on why the big banks should not be dismantled.  See Don't Break Up the Megabanks  The article asserts that doing so is radical, costly, and will not necessarily enhance stability.  The article also asserts that reform is working and community banks have more influence than the megabanks.  

Much of the discussion addresses straw arguments.  For example, in describing a breakup as "radical," the article asserted that the "United States government does not normally cap the size of private firms, even gigantic firms like Apple or Wal-Mart. Who would invest in a company that’s legally prohibited from growing?"   It would be unusual and logistically difficult to impose an arbitrary limit on size.  This is, therefore, a highly unlikely method of downsizing megabanks.  

A more likely method would be to limit the types of activities that can be conducted by the megabanks.  Thus, they could grow but not in all segments.  The Volcker Rule was a half hearted step in this direction.    

More directly, however, the article missed the single most important reason altering the size and activities of the megabanks.  Back in 1996, I wrote a piece predicting that, with the repeal of Glass Steagall, investment banks as a separate class of intermediaries would disappear and that the market niche would become dominated by commercial banks.  See The "Great Fall": The Consequences of Repealing the Glass-Steagall Act 

This wasn't a guess; the process had been underway when Congress halted it by adopting Glass-Steagall in the 1930s.  Moreover, over the long term, commercial banks have inherent advantages, including access to deposits and the discount window.  Without artificial barriers, commercial banks will eventually squeeze out the investment banks.  

This prediction made in 1996 came to pass a bit over a decade later.  When the 2008 crisis began, there were five world class investment banking firms in the US.  That quickly changed.  There was the sale of Bear Sterns to JP Morgan, the purchase of Merrill by BofA, and the collapse of Lehman.  Goldman and Morgan Stanley converted to commercial banks.  

Does this matter?  When investment banks existed, they essentially made their profits through risk taking in the the securities markets.  This benefited the markets and made them more dynamic.  Commercial banks are by definition more conservative both because of the oversight by bank regulators (who are permanently on site) and the need to protect deposits.  As a result, the elimination of investment banks as a separate class of intermediaries has likely resulted in reduced risk taking in the securities markets.  This has the potential to cause long term harm to the securities markets. 

Policies with respect to the megabanks should be designed with an eye towards strengthening the securities markets.  Reducing the megabank footprint in the investment banking space would make them smaller and less risky.  It would also allow for the reeemergence of a class of intermediaries designed to ensure the vibrancy of the US securities markets.   

J Robert Brown Jr.