Make financial reform about simplicity

President Donald Trump’s top economic adviser — former Goldman Sachs executive Gary Cohn — has come out in favor of a radical reform: restoring the Depression-era Glass-Steagall Act, which for much of the 20th century separated bread-and-butter commercial banking from high-octane investment banking.
The thinking behind this proposal is appealing. The basic idea is to narrow the scope of financial activities that taxpayers support through deposit insurance and emergency loans from the Federal Reserve. In principle, this makes a lot of sense. The challenge is to do it in a way that simplifies the overly complex rules that banks and other firms have had to contend with since the Dodd-Frank reforms. Glass-Steagall isn’t the best approach.
The problem with having the Fed stand behind deposit-taking firms that also trade in securities and derivatives is that it creates all kinds of distortions. For one, it tends to bloat banks’ securities operations, undermining market discipline and putting smaller, more nimble competitors at a disadvantage. Worse, banks’ large derivatives businesses present a threat to the deposit insurance system. In a crisis, counterparties can grab cash that would otherwise go toward paying back depositors.
The question, then, is how best to limit this taxpayer support. The solution favored by Dodd-Frank reform was the Volcker rule — a kind of Glass-Steagall lite. This tries to draw the line at banks’ own speculative trading, which is hard to distinguish from the trading banks do on behalf of customers.
Straight-up Glass-Steagall would be flawed in another way. As the last crisis proved, if a financial institution is systemically important and depends on short-term funding that can flee in a panic, the Fed will have little choice but to support it in an emergency — no matter whether it’s called a commercial bank, an investment bank or an insurance company. And that unspoken obligation makes it harder to cut the regulatory overload.
A solution proposed by Mervyn King, former head of the Bank of England, is more promising. Any financial institution accepting deposits or issuing other kinds of short-term debt would have to pledge assets to the Fed, in return for guaranteed access to emergency loans if they’re needed. By defining the eligible assets and the haircuts it would impose on the collateral, the central bank would say in advance precisely which lines of business taxpayers would back. This would stop bank runs before they start — and there’d be no need for deposit insurance or the current panoply of liquidity and other rules.
Ample equity capital would still be needed to ensure that banks and other financial firms could weather the losses that inevitably come from time to time. But that, together with something similar to what King proposes, could replace hundreds of pages of Dodd-Frank-related regulations while making the financial system stronger. If Trump and his team are willing to be radical, that’s a better way to go.
—Bloomberg