The Repeal of Glass Steagall Did NOT Cause the Financial Crisis (or income inequality)

In fact, it helped to alleviate it.

Let us review what Glass Steagall did.  It forbid deposit taking banks from trading securities in the United States.  But they could trade United States Treasuries, municipal bonds, foreign exchange, and gold.  So U.S. based banks traded other securities in foreign affiliates which were exempt from U.S. law, but not U.S. regulation for safety and soundness.  The investment banks, which were allowed to trade securities in the United States, were also lightly regulated for safety and soundness, but not as rigidly as the deposit taking banks.

So all the repeal of Glass Steagall did was allow U.S. based deposit taking banks to trade all securities in the United States entities.

So what happened in 2008?  Washington Mutual and Countrywide (mortgage banks) failed or were sold on the brink of failure.  Both were deposit taking banks that did not trade securities.  Bear Stearns and Lehman Brothers, both investment banks, failed causing a financial crisis in which liquidity was withdrawn from all banks.  One of the basic functions of the Federal Reserve, and every other Central Bank, is to be the Lender of Last Resort and provide liquidity to the banking system when there is a liquidity crunch.  That is what the Federal Reserve did in 2008.  But something else happened in the liquidity crunch.  Some institutions that did not have access to the Federal Reserve were having liquidity calls on derivative positions and did not have the cash to make those payments.  Merrill Lynch and AIG come into the picture here, neither a deposit taking bank.  And Goldman Sachs had too much exposure to AIG and would be seriously harmed and possibly fail as a result. Goldman Sachs is not a deposit taking bank.

Let me change subject for a minute.  The economy is made up of Labor and Capital.  Together they equal GDP and are what keep the economy functioning and people employed.  If you shrink either one, you create a recession or a depression (which is a very serious recession).  When any company fails, debt and equity values are written off, they are made worthless.  That loss of value is a reduction in capital and directly results in a loss of GDP as employment is reduced.  

The thing about the the mortgage banks and the non-deposit taking investment banks is their balance sheets totaled into the hundreds of billions of dollars.  You cannot wipe out 5% to 10% of GDP and not cause a more serious recession than you are already in.  To be replenished, capital must come from income and that takes time to rebuild.  In the meantime, employment is reduced directly in the firms that fail and the firms that supplied services to those now unemployed people so that other firms harmed by this failure can rebuild from the remaining profitability.

But the thing to remember about these liquidity starved firms is that their failure was caused by the mark-to-market of their assets and fear.  Yes, they had some bad assets, but they also had equity.  Yet, lenders fled.

And who saw value in buying these institutions at cheap prices, the deposit taking banks who had not failed and had been supported by the lender of last resort.  So JP Morgan bought Bear Stearns for the value of their building, Bank of America overpaid for Merrill Lynch but has still made some money on it.  I don't know why these same banks rescued Washington Mutual and Countrywide, but I suspect the legal liability was underestimated and absent that the economics would have worked.

But the point is, both JPM and BAC were stronger because of the diversity of their revenues and that put them in a position to make timely acquisitions and stabilize the economy.  That is what you want to happen in a liquidity crisis.  You want to cutoff the panic because panic exacerbates the recession.

2008 happened because the mortgage industry was poorly regulated.  Too much credit was extended to people who could not pay it back and when those loans were written down, capital shrank and a recession occurred.  The financial crisis was caused by that, and if that hadn't happened, there wouldn't have been a financial crisis.  The mortgage industry didn't need Universal Banks like JPM, Citibank or BAC to do what they did.  They could have done it with just the mortgage banks and the investment banks.

That is why there must be regulation of all aspects of the lending system.

That is what Dodd Frank accomplishes.  And all reinstating Glass Steagall would do is reduce diversity of Big Bank earnings and their financial strength.

So Bernie Sanders and Martin O'Malley, you were wrong last night to call for a reinstatement of Glass Steagall.  Glass Steagall or something like it will not solve income inequality.