On Wall Street’s big banks, Trump and the Democrats are both wrong

A street sign for Wall Street is seen outside the New York Stock Exchange (NYSE) in Manhattan, New York City, U.S. December 28, 2016. REUTERS/Andrew Kelly - RTX2WRNR
Editor's note:

This piece originally appeared in The Hill on August 7, 2017.

In Trump’s campaign for president, he pledged to bring back Glass Steagall, and that same pledge was included in the Republican Party platform. Glass Steagall was a depression-era law limiting the financial activities of banks, which was repealed in 1999. But what does it mean to support a modern version of this act?

The Trump administration has given confusing answers to this question. Meanwhile, liberal Democrats have made clear that they mean breaking up the large banks. These issues will have to be sorted out by Randal Quarles, who will soon gain Senate approval to be the first vice chair for regulation at the Federal Reserve.

In my view, a sensible middle ground would be the new British model of “ring fencing” — narrowly confining a bank to insured deposits and traditional loans, while allowing a much broader array of financial activities in a separate subsidiary of the same bank holding company.

In a private meeting with several senators in April, Gary Cohn — the president’s chief economic adviser — reportedly supports the separation of consumer loans from trading and underwriting securities at large Wall Street banks. Similarly, when President Trump was asked in May about splitting the consumer businesses of Wall Street banks from their investment operations, he replied, “I am looking at that right now.”

Yet, during a Senate hearing later in May, Treasury Secretary Steven Mnuchin announced a different position for the Trump administration on Glass Steagall reform. “We do not support the separation of banks from investment banks,” he told lawmakers. At that hearing, Sen. Elizabeth Warren (D-Mass.) excoriated Mnuchin for reversing President Trump’s public position, correctly stressing that separating commercial from investment banking was the core of Glass Steagall.

Warren, along with several other senators, has introduced a bill known as the 21st Century Glass Steagall Act, to protect U.S. taxpayers against bailouts of financial institutions. That bill, which has little chance of passing Congress, would require large banks to completely divest their securities underwriting and trading units.

Unfortunately, this bill is based on the premise that securities trading and underwriting by the large banks were key causes of the financial crisis of 2008. However, that premise is wrong. During 2008, the financial institutions that failed were mainly nonbanks. Remember broker-dealer Lehman Brothers, insurance company AIG and mortgage company Fannie Mae?

The federal government did recapitalize several large banks, such as Citigroup and Bank of America. But their securities trading and underwriting activities were profitable during this period. These banks incurred huge losses by making bad real estate loans and investing in mortgage-backed bonds that defaulted. Such loans and investments by banks would have been permitted by the Glass Steagall Act before its repeal.

If Congress aims to reduce federal bailouts of financial institutions, Congress should closely examine the British model of a holding company with two separate subsidiaries. Thomas Hoenig, chairman of the Federal Deposit Insurance Corporation, has championed this model, which might be considered by the Trump administration, according to Treasury Secretary Mnuchin.

One subsidiary would be a narrowly-defined bank, which would be well capitalized and engage in relatively low-risk activities. It would be funded mainly by federally-insured deposits plus interbank borrowings, and would make only specified types of loans such as home mortgages, consumer loans and commercial loans to small and midsize businesses.

The other subsidiary would not be financed by federally-insured deposits and therefore could engage in a broader range of activities such as securities underwriting, trading bonds or commodities, and brokering certain types of insurance and real estate. In addition, the diversified subsidiary could not obtain loans or other forms of capital from the bank, which could provide the diversified subsidiary with only limited kinds of services on market terms.

Nevertheless, the argument would be that, if the diversified subsidiary got into trouble, it would be bailed out by the bank holding company — which would draw resources from the bank. To mitigate this possibility, Congress should limit the support of the bank holding company to a specified portion of the capital of the diversified subsidiary. The diversified subsidiary should also be required to issue a significant amount of subordinated debt, convertible to equity in the event of serious troubles.

In short, the Trump administration has no workable definition of a “21st Century Glass Steagall Act,” and the liberals’ call to break up the large banks is not politically feasible. Instead, Congress should focus on the goal of reducing federal bailouts of banks and other financial firms if their assets exceed a specified level such as $250 billion.

To accomplish this goal, Congress should seriously consider the British model of a well-capitalized bank funded by government-insured deposits with limited risk exposure — kept as separate from a sister subsidiary engaged in more diversified activities without funding from government-backed sources.

Robert Pozen has been a nonresident senior fellow at Brookings since 2010. In 2015, he generously committed to endow the Director’s Chair for the Urban-Brookings Tax Policy Center. Until 2010, Pozen was executive chairman of MFS Investment Management and, before 2002, served in various positions at Fidelity Investments. He did not receive financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. He is currently not an officer, director, or board member of any organization with an interest in this article.