Elizabeth Warren

A new Glass-Steagall won't prevent another financial crisis

July 15, 2013: 10:23 AM ET

Is the Depression-era bank legislation the right solution for today's too-big-to-fail problems?

Senator Elizabeth Warren

Senator Elizabeth Warren

FORTUNE -- When banks behave badly, leave it to the Glass-Steagall Act to save the day.

Such has been the mantra in the years following the 2007-2008 financial crisis -- the latest from U.S. senators Elizabeth Warren (D-Mass.) and John McCain (R-Ariz.). The Depression-era law prevented commercial banks from also taking on business ordinarily done at investment banks. Its repeal in 1999 has been blamed for encouraging risk and greed and much that's wrong on Wall Street; without Glass-Steagall, banks got bigger, and over the years, "too big to fail."

Last week, the unlikely political pair introduced a bill aimed at recreating the 1933 law. The effort is welcomed, but the protections of Glass-Steagall aren't a cure-all for bank risk today -- its repeal didn't cause the financial crisis. And reinstating the law likely won't protect Americans from another one.

This isn't to say a law like Glass-Steagall isn't needed. Warren and McCain's proposal would separate traditional banks that offer your standard checking and savings accounts insured by The Federal Deposit Insurance Corp. from riskier institutions, such as those involved in investment banking, the sale of insurance products, hedge funds, private equity, and the like.

MORE: Citi rebound continues

This could certainly limit risks in the financial system -- something that's badly needed as banks have increasingly taken on more risks, and have grown too big and too fast.

Even the most unlikely bankers, such as former Citigroup (C) CEO Sandy Weill, have called to essentially bring back the law. Recall, Weill built Citi, what was once the world's largest bank, into the financial "supermarket" it was when the financial crisis hit.

Reinstating something like Glass-Steagall, however, won't protect Americans from reliving another financial crisis. True, overturning the law likely made the crisis worse, as Barry Ritholtz, has noted. It encouraged a financial system that wrongly assumed that banks can self-regulate; financial institutions were allowed to get bigger, more complex, and much too leveraged.

But the repeal of Glass-Steagall alone likely didn't cause the financial crisis or last year's $2 billion-plus trading loss at JPMorgan (JPM) (it happened on the commercial side of the bank and not at the investment bank arm) -- something Warren herself acknowledged in an interview last year with New York Times reporter Andrew Ross Sorkin. Recall, the first banks to crack in the financial crisis were Bear Stearns, Lehman Brothers, and Merrill Lynch -- all investment banks without commercial banking businesses covered under Glass-Steagall.

MORE: Higher interest rates: A bitter pill for banks

To be sure, Citigroup's huge losses and its subsequent government bailout may not have happened if Glass-Steagall were still in place. Citicorp and Travelers Group would not have been able to merge into the world's biggest financial-services company.

What all this speaks to is the complexity of financial regulations and what's needed to safeguard U.S. taxpayers from the risks posed by today's banks. Bringing back a law like Glass-Steagall would certainly reduce the risks posed by America's too big to fail banks, but it won't remove them. Warren herself has acknowledged her proposal faces big political hurdles. If she's successful, however, it would be too idealistic to say that another financial crisis won't occur.

Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by WordPress.com VIP.