Big Bank Phobia: Glass-Steagall Would Be Folly

This is the third of a three-part series rebutting the three most popular approaches toward lowering the systemic risk of large U.S. banks. Part one tackles breaking up the banks and part two deals with capital vs. liquidity.

NEW YORK ( TheStreet) -- Bringing back the complete separation of investment banks from commercial banks would not strengthen the U.S. financial system, but it would make future bailouts more likely.

This is the third of our three-part series rebutting the three major ideas for ending the perception that the nation's largest banks are "too big to fail," this time focusing on why bringing back the Glass-Steagall amendment to the Banking Act of 1933 would be a bad idea.

In part one we discussed the prospects of simply breaking up the six largest U.S. banks, including JPMorgan Chase ( JPM), Bank of America ( BAC), Citigroup ( C), Wells Fargo ( WFC), Goldman Sachs ( GS) and Morgan Stanley ( MS). The easiest way for politicians to achieve that goal, rather than passing legislation directly to break them up, would be to increase the capital ratio requirements for the big six banks so high that their shareholders would conclude breaking up would be the only choice.

In part two, we pointed out that a narrow focus on capital levels is not enough to make sure large banks can weather the next economic storm without relying on a government bailout. The immediate catalysts for bank failures have been shortages of liquidity, not capital. The Federal Reserve needs to incorporate lockups of wholesale liquidity and retail bank runs in the "severely adverse scenarios" used by the regulator in its annual stress tests.

It's Easy to Say 'Bring Back Glass-Steagall'

Some of the people clamoring for the breakup of the nation's largest banks also think it would be wise to bring back Glass-Steagall's separation of investment banks from traditional commercial banks. The Federal Reserve was already taking a liberal approach to Glass-Steagall even before the Graham-Leach-Bliley Act of 1999 formally ended restrictions against investment banks affiliating with commercial banks.

Even after Graham-Leach-Bliley was passed, there were still several very large investment banks, or broker/dealers. Having them separated from commercial banks "didn't stop us from having the last financial crisis, because as we saw, the institutions under the greatest pressure were the independent broker/dealers, including Lehman Brothers, Bear Stearns and Merrill Lynch," says Guggenheim analyst Marty Mosby. "These companies didn't have enough liquidity or enough capital."

By their nature, independent broker/dealers rely on short-term or overnight liquidity to fund their balance sheets. They lack the stable retail deposit bases of commercial banks.

After Bear Stearns saw its wholesale liquidity dry up almost instantly, and following an attempted bailout by the Federal Reserve, the company was acquired by JPMorgan Chase in June 2008. Faced with a similar lockup of overnight credit, Lehman Brothers went bankrupt in September 2008. Facing its own liquidity crisis, Merrill Lynch agreed to be acquired by Bank of America, in a deal that was completed in January 2009.

The two largest independent investment banks -- Goldman Sachs and Morgan Stanley -- converted to bank holding company structures at the height of the credit crisis during 2008. This greatly reduced liquidity pressure on the firms, as they were granted access to the Federal Reserve's discount window. The firms have also been able to grow retail deposits, although these still make up small portions of their funding.

Goldman Sachs had $72.7 billion in deposits as of March 31, with total assets of $959.2 billion. At the end of the company's fiscal 2007, the company had just $15.4 billion in deposits, with $1.077 trillion in total assets. Deposits funded 7.5% of Goldman's balance sheet as of March 31, but this was up from a miniscule 1.4% at the end of fiscal 2007.

Morgan Stanley had $80.6 billion in deposits as of March 31, with total assets of $801.4 billion. At the end of fiscal 2007, Morgan Stanley had $31.3 billion in deposits and $1.045 trillion in assets. With the deposit increase and balance sheet shrinkage, Morgan Stanley now has deposits funding 10.1% of total assets, increasing from 3.0% at the end of fiscal 2007.

Even though Goldman and Morgan Stanley still have relatively small deposits, the companies have made significant progress in solidifying their liquidity.

In addition to the deposit growth, the conversion of Goldman and Morgan Stanley to bank holding company structures has caused the companies to file uniform financial statements with the Federal Reserve, allowing for easy comparison to other large banks. The conversion has also brought the companies directly under the Fed's regulatory and supervisory umbrella, which includes the stress tests and reviews of annual capital plans.

There's no question that Goldman and Morgan Stanley are stronger and better regulated institutions now that they are bank holding companies.

Don't Split Them Up

In a report on Monday considering alternatives to the breakup of the nation's largest banks, Mosby pointed out that "JPMorgan Chase has been active in broker/dealer activities throughout the evolution of the U.S. financial system," and that the company's structure "hasn't seemed to push this financial institution in harm's way." Bear in mind that JPMorgan Chase, along with several other large banks that received federal bailout funds in October 2008 through the Troubled Assets Relief Program, or TARP, was specifically directed by then Treasury Secretary Henry Paulson to accept the money. Or else. JPMorgan repaid TARP in June 2009.

Mosby neatly summed up the argument against bringing back Glass-Steagall:

"During the last financial crisis, the escape hatch was to consolidate the stressed broker/dealers into the safety of the diversified banks. By nature, independent broker/dealers require less capital, and the use of leverage is a fine-edged sword that can push these firms to the edge."

"On the other hand, we believe that by incorporating market making and investment banking into the overall commercial banking relationships of traditional banks, the need to generate these incremental revenues through riskier activities is minimized," Mosby wrote.

Mosby does agree with the stipulation under the Dodd-Frank Wall Street Reform and Consumer Protection Act that banks should have their "broker/dealer activities limited to just market making. This is known as the Volcker Rule, and its implementation has not yet been finalized by the Federal Reserve. But "it is more important to limit principal transactions than totally remove these activities," Mosby wrote.

In the end, it's obvious the independent broker/dealers were at a severe disadvantage during the credit crisis, because their funding dried up almost overnight. Separating investment banks and/or broker/dealers from the big six U.S. banks would create large new entities that would quickly find their backs to the wall in a repeat of the 2008 crisis.

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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