A return to Glass-Steagall to prevent another crash? A lesson from economic history.

At the World Traders’ Tacitus lecture last night, Terry Smith proposed a return to the provisions of the Glass-Steagall Act in order to reform the banking sector. The title of his lecture was ‘Is Occupy right?’, and while he clearly didn’t go along with some of the propositions of the Occupy movement, such as the imposition of a financial transaction tax, he did say that they have a serious point to make about the financial system.

The Glass-Steagall Act was passed in the US in 1933 as a response to the 1929 Stock Market crash, the failure nationwide of commercial banking, and in midst of the Great Depression. At the time, “improper banking activity”, or what was considered too much risky commercial bank involvement in stock market investment, was deemed to be the main culprit of the financial crash. The act therefore set up a firewall between commercial banking and investment activities, with controls imposed on both. Does this sound familiar? Take a look at the proposals of the Vickers Commission in the UK and the Volcker rule in the US, and you will find that ironically regulators are looking at bringing in very similar controls now, in order to prevent another crash like that of 2008.

These re-imposed controls are needed because Glass-Steagall was repealed in 1999 during Bill Clinton’s presidency. For more than six decades it had provided a framework that had governed the functions and reach of the nation’s largest banks. The Act was repealed, as a move to liberate financial markets. It was called the ‘Financial Modernisation Act’, was passed by 90 votes to 8 in the US Senate and was hailed as the most important breakthrough in the worlds of finance and politics in decades. However it caused great concern among some economists about the implications of creating banking institutions which were too big to fail.

The Huffington Post reports some of these concerns. Edward Kane, a finance professor at Boston College warned against this move in 1999 and ten years later said “It made it possible for the very big firms to take risks in a way that would require a great deal of investment risk and time for regulatory agencies. You had people who could basically outplay the regulators.” Jeffrey Garten, who at the time had left his post as Undersecretary of Commerce for International Trade at the Clinton White House, wrote in the New York Times that if these new “megabanks” were to falter, “they could take down the entire global financial system with them.”

Prescient words, which suggest that removals of regulation created the opportunity for sub-prime lending and the intricate web of credit swaps and other obscure financial instruments which led to the crash and credit crunch. Mr Smith suggested that Big Bang in the UK in 1986, which scrapped fixed commissions on Stock Market deals and made London a more competitive location for trading, created conflicts of interest between brokers and clients, which contributed to the same effect. He also referred to the bonus culture, which doesn’t evenly share the downside risk of bad deals, and to the fee structure in hedge funds which doesn’t allow a fair sharing of the upside risk but passes on to the client all of the trading fees, but only a proportion of the profit.

His conclusion was that yes, Occupy is right to say that the markets need harsh reform. But his view was that, within new regulation, they need to be more free - with the freedom to fail as a result of Creative Destruction in markets, without the need to be bailed out because they are too big and too complex.