Glass-Steagall Would Have Prevented the 2008 Crash
by Paul Gallagher, Economics Editor, EIR
Aug. 25, 2015 (EIRNS)—The following oped was written yesterday as part of the ongoing debate on reinstating Glass-Steagall. Bills to do that (S. 1709 and HR 381) are now before both Houses of Congress.
Former President Clinton merely repeated the excuse of his former Treasury Secretary Robert Rubin, who tells all who ask about Glass-Steagall, “It wasn’t being enforced; repeal made no difference.” In truth, it made all the difference in generating the 2007-08 bank panic.
Progressive elimination of Glass-Steagall over 1994-99 had dramatic effects on U.S. banking. The failure merely of a large hedge fund—Long-Term Capital Management—nearly broke the banking system in 1999 because 55 banks had poured leveraged loans into it—action not permitted to them under Glass-Steagall. The largest banks became impossibly complex, going from typically 1-300 subsidiaries to typically 2,500-4,000 subsidiaries, buying and creating what were overwhelmingly securities and broker-dealer vehicles. The derivatives markets exploded geometrically with the flow from depository giants, from about $70 trillion notional value in 1997 to $700 trillion in 2007 according to the Bank for International Settlements. The largest banks became entirely interconnected with one another, particularly through their mutual derivatives exposures—thus a Lehman could not fail without bringing down all the others. Their leverage ratios were allowed to rise from typically 16:1 to 30-35:1. Loans/leases assets fell to about half of total assets, while the banks became rapidly larger.
After being saved with bailouts which at one point reached $14 trillion according to former FDIC chair Sheila Bair, the largest banks’ lending fell; the whole banking system’s loan/deposit ratio fell to a historically low 70%.
FDIC vice-chairman Thomas Hoenig described the current situation in a May 6 speech at the Boston Economics Club: “The largest banking firms also have tended to increase their complexity. They have used the safety net subsidy to support their expansion across the globe. They have further combined commercial, investment banking, and broker-dealer activities. There have been no fundamental changes in the wholesale funding markets, in the reliance on bank-like money market funds, or in the use of repos, which all are major sources of volatility in times of financial stress. They remain excessively leveraged with ratios, on average, of nearly 22 to 1. The remainder of the industry averages below 12 to 1. The average notional value of derivatives for the three largest U.S. banking firms at year-end 2013 exceeded $60 trillion.”
The condition of the largest banks in London and the European Union is much worse. The trans-Atlantic banking system is headed for a general crash, unless we restore Glass-Steagall principles of regulation.