The New York Times

November 11, 2009
Op-Ed Contributor

Too Big to Succeed


HONG KONG — This week is the 10th anniversary of the signing by President Clinton of legislation abolishing the Glass-Steagall act, which, since 1933, had kept a wall between commercial banking and investment banking and insurance. That Depression-era law stemmed from the role that speculative investment banking had played in the failure of many commercial banks, which in turn wrought havoc on the U.S. economy.

The abolition, passed by a large majority in Congress, was strongly supported not only by the big names on Wall Street but by the then Treasury secretary, Lawrence Summers, and his immediate predecessor Robert Rubin, a star of Goldman Sachs. Glass-Steagall was, it was argued, outmoded and a barrier to innovation and competition. I was then in a minority in worrying about the return of huge financial consortiums. But events suggest that the essential wisdom of Glass-Steagall remains intact. Separation of powers and functions should be as important to the finance sector as to the U.S. Constitution.

By the 1990s, Glass-Steagall was certainly out of date, having been bypassed by financial sector developments, astute lawyers and compliant officials. However, the principle enshrined in it — that finance should be compartmentalized to prevent problems in one sector from wreaking havoc on the whole industry — remains valid. Today, even those who most strongly supported abolition are having second thoughts. They include John Reed, former chairman and chief executive of Citigroup and the man primarily responsible for turning Citibank, a world leader in commercial banking, into a conglomerate with investment banking, insurance and broking interests. Mr. Reed recently noted the wisdom of compartmentalized ship design: “If you have a leak the leak doesn’t spread and sink the vessel.”

Since 1999 there have been three financial sector crises that in different ways have shown the dangers of financial arrangements with internal conflicts of interest, a tendency to cross-sector infections, and emergence of the “too big to fail” mentality that has cost American taxpayers billions in bailouts.

The end of Glass-Steagall coincided with the last surge of the tech stock frenzy, which peaked in early 2000. The economic damage done by that boom and bust was relatively modest as it was mostly not financed by debt. But it showed how failure to keep financial activities in their proper compartments led to conflicts of interest that helped drive prices to absurd levels and made gigantic profits for intermediaries at the expense of the public.

Investment banks and stockbrokers tailored their research not to the needs of public investors but to maximizing profit from their primary share issue business. They had a close relationship with a mutual fund industry, which focused on short-term returns and over-rewarded managers accordingly. They also fostered a stock options culture among corporate executives aimed at maximizing short-term share performance to enable them to cash-in quickly.

Since the tech stock crash there has been some strengthening of the walls between investment bank and broker research, and increased competition in the mutual fund industry. But “compliance departments,” which are supposed to keep investment banks honest, are often staffed by the meek and bureaucratic.

Nor did the tech stock crash resolve another conflict of interest in an increasingly concentrated financial services industry. The Enron collapse in October 2001 underlined both the zeal of investment banks to create opaque structures to hide debt and the willingness of some auditors, seduced by high fees, consultancy contracts and golf course friendships, to sign off on dubious accounts. The consequent collapse of Enron’s auditor, Arthur Andersen, may have led to some improvement in standards. But it further reduced the number of big name auditors and strengthened the cartel tendencies of an industry that exists to serve the interests of outside investors and creditors, not management.

Over the past 18 months the whole world has suffered from financial sector abuse that was only possible because a few institutions combined several of the roles of commercial banks, primary dealers, derivatives traders, bond underwriters, fund managers, insurers, merger specialists etc. Now an even tinier group of top firms still make most of their profits from “trading,” a euphemism not just for commissions on trades in which they are intermediaries but trades on their own account that can often only be profitable at the expense of clients of another part of their business.

Foreigners who look to the United States for financial leadership need no reminding that international icons like Citigroup, Merrill Lynch and A.I.G. have been brought to their knees. For decades these icons had done much to facilitate the development of global trade and cross-border investment and spread best practices in banking, brokering and insurance. But when they tried to combine all these specialties they became not just “too big to fail” but too big to succeed.

The Glass-Steagall principles should form a basis for discussion by G-20 ministers who were again last weekend getting nowhere in their promised efforts to improve the stability and transparency of global finance.