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."

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