BANKING

ITHICA, N.Y. — The Treasury Department is preparing a controversial bill that would radically change the financial services industry. Parts of the bill are already under review at the White House. This bill would dismantle the Glass-Steagall Act, which separates commercial banking and investment banking. Proponents of the bill are even discussing a mild relaxation of the strict rules that completely ban banks from involvement in commerce.

Of course, there have been plenty of proposals to reform the nation’s antiquated banking laws over the past 60 years. There were a half-dozen serious reform efforts during President Bill Clinton’s first term. But the current Treasury proposal is different because it holds out the possibility of relaxing the prohibition separating banking and commerce. This attracts the support of big business, including some insurance interests that have long opposed any reform of financial services. The industry conditions its support of reform on stripping banks of their existing power to broker insurance. The Treasury bill pits those who underwrite insurance and want reform against those who broker insurance, who oppose it.

The chief justification for reforming Glass-Steagall is a growing fear that America’s weak commercial banks, never dominant players on the world stage, are growing even weaker. The regulators claim that new legislation is needed because U.S. commercial banks aren’t competitive with the big German and Japanese universal banks. This worries bank regulators, who understand their own power is tied to the continued viability of the industry. The recent wave of purchases of British investment banks by giant German banks has increased concerns about the future competitiveness of the U.S. banking industry.

These regulators have reason to be worried. In the past 20 years, the banking industry’s share of U.S. financial assets has fallen from 60% to less than 30%, and U.S. banks no longer appear on lists of the world’s major financial institutions. Bank of America, once America’s premier financial institution, now plays second fiddle to U.S. investment banks on the global stage. Today, investment banks are the only U.S. firms in significant leadership roles internationally. Aging laws are driving commercial banks to obsolescence. Instead of borrowing money from banks, big companies can raise capital more cheaply by selling bonds, commercial paper and sometimes even stock.

The leading opponent of the current legislative proposals is Sen. Paul S. Sarbanes (D-Md.), the ranking Democratic on the Senate Banking Committee. He is lobbying furiously to oppose the Treasury proposal and is working with an assorted conglomeration of interest groups led by the Independent Bankers Assn. of America, which fears the new competition that deregulation would bring. Sarbanes takes his cues on banking from his ally, former Sen. William Proxmire, who was an influential chairman of the Senate Banking Committee. Proxmire says competitive banking markets were less important than the populist ideals of “decentralized power” and “local allocation of credit.”

The trouble with this approach to bank regulation is that it subsidizes poorly managed, unprofitable banks at the expense of aggressive, profitable banks. That subsidy began with the passage of the Banking Act of 1933 and continues to this day.

Current banking laws punish big, well-managed banks in two ways. First, before the 1933 legislation was enacted, depositors were justifiably worried about putting their money in small, undiversified, local banks. After all, economic research demonstrated that more than 90% of the banks that closed during the Depression were one-office banks in small towns that collapsed together with their surrounding economies. Consequently, in the early 1930s, small banks pushed for deposit insurance and geographic restrictions on bank expansion so they would stop losing deposits to the local branches of big banks. Almost no big banks failed during the Depression.

Second, the securities activities of larger banks were falsely blamed for causing the stock market crash that heralded the Depression. This false accusation led to the Glass-Steagall Act that keeps banks out of the securities business. In fact, banks with securities operations were less risky than banks that did not have such operations--as measured by the likelihood of insolvency. Other, more technical measures of riskiness, such as capital levels and stability of earnings, confirm the fact that combining securities business with commercial banking makes banks less risky, not more. For example, in the bank crisis between 1930 and 1933, more than 25% of all national banks failed, but less than 10% of those with securities operations became insolvent.

These results make sense intuitively. A bank with a securities operation is better diversified than a bank without one. The diversified bank can make money on securities activities when commercial banking is unprofitable. But with Glass-Steagall separating commercial banking from investment banking, banks can’t diversify into investments. This is a major problem since technological change is improving the quality of securities markets, making the securities business far more important than traditional banking.

When banks’ securities activities were blamed for the stock market crash, banks were accused of manipulating the market, underwriting and selling unsound and speculative securities, propping up shell companies to profit by selling securities, and every other form of financial crime, including insider trading. Just as it might seem logical to think that fire engines cause fires, because they are always around when there are flames, so too, it seemed logical to blame the nation’s economic woes on banks. After all, after the 1929 crash, commercial banks started failing by the thousands.

And banks kept failing throughout the Depression. In 1933, the year the nation’s banking laws were overhauled, 4,000 banks failed. But the reality is that banks were brought down by the general economic collapse. Careful empirical studies have shown that securities firms with ties to banks underwrote and sold higher-quality issues, whose prices declined by less than comparable issues underwritten by investment firms with no bank affiliations.

The Treasury plan to reform the banking system is an important step toward making U.S. commercial banks competitive globally. While the plan does not go nearly far enough in allowing commercial banks to engage in commercial activities, it promotes efficiency by allowing banks themselves, through directly owned operating subsidiaries, to engage in the securities business.

In this way, the Treasury plan, unlike other proposals, would allow banks themselves to reap the benefits of higher profits at lower overall risk that come with combining banking and securities activities. In every country where banks can engage in securities activities directly, they do so. Requiring that securities activities remain in complicated bank holding-company affiliate structures is outmoded and inefficient. This is the sort of legal structure the Federal Reserve wants, because the Fed regulates these holding-company affiliates but not the banks themselves--and the Fed wants to protect its bureaucratic turf.

The Treasury plan is equitable because the costs of setting up and operating the different corporate structures necessary to comply with the current rules keep small and medium-sized banking organizations out of lucrative financial services businesses. Perhaps most important, because banks have federal deposit insurance, while their affiliated companies do not, the higher profitability and lower risks associated with allowing banks to engage in securities activities directly will not be lost under the Treasury proposal.

Opponents of the current reform effort characterize the battle as the big banks against the little guys: Wall Street vs. Main Street. The reality is that the Treasury plan does not go far enough to reform the nation’s antiquated banking laws. The consumer is losing out to the special interests once again.