How the US Financial System Is Designed to Be Fragile

This is the tenth in a series on banking that begins here.

“What’s critical, of course, is that any change protects the core principle: ‘Thou shalt not gamble with the public’s money.’”

Paul Volcker, Former Head, The Federal Reserve Bank

This topic about system fragility is inspired by the book by economists Charles W. Calomiris and Stephen H. Haber, Fragile by Design, mentioned at the beginning of this section on banking. These authors wondered why the Canadian banking system was so stable that the banks rarely failed and didn’t need a bailout in 2008. They investigated and concluded that it was no accident, it was a better design.

The security of the Canadian systems is based on the belief that the three aspects of the financial system: commercial banking, investment banking, and insurance should be kept in separate silos like watertight compartments on an ocean liner. History has shown that their business cycles were different. When one would go down, the other two would be up, resulting in more stability to the system as a whole.

And separation was the key for FDR’s solution to the bank crisis in the 1930s known as Glass-Steagall (1933). This legislation:

• Separated the commercial and investment banks

• Established deposit insurance for the commercial banks

• Absolutely prohibited commercial banks from speculating in the markets including derivatives

And that separation of the two financial industries provided a stable US financial system from the 1930’s to 2008.

Recall that The Big Short showed how the banks were betting billions with the hedge funds that the housing market would continue to go up using the Credit Default Swap. This put depositor money at risk. Deposit money is not held in trust and can be seized by bank creditors. (Insurance company AIG also got into the betting game exposing all three sectors). For more on this see Demystifying High Finance.

As early as 1914, Louis Brandeis identified the need to prohibit commercial banks from risking deposit money to gamble in investments for banker bonuses. The title to his book was a warning about this practice: Other Peoples’ Money, And How Bankers Use It. This book provided the understanding in the voting public that allowed legislation in 1933 to prohibit commercial banks from using depositor money for anything other than making loans.

Fragility Replaces Stability

The undermining of the separation of the two bank types occurred in 1997. Sandy Weill, wanted to merge his investment banks, Salomon Brothers and Smith Barney, subsidiaries of The Travelers Group insurance company with Citicorp, parent of Citibank, a commercial bank. This would create a ‘universal bank’ for financial one stop shopping: insurance, investing and borrowing.

Instead of prosecuting the group for the blatant violation of Glass-Steagall, the Clinton government immediately acquiesced and replaced FDR’s legislation with the Financial Services Modernization Act of 1999, more commonly known by the tongue twisting, Gramm–Leach–Bliley Act (GLBA).

The merger of the three financial industries, commercial bank, investment bank and insurance company was now approved and the stage was set for the 2008 meltdown.

Clinton cannot take all the blame. He was influenced by the leading economists of the day. They unanimously held to the neoliberal ideas in economics — which is a somewhat misleading term. Liberal in politics is usually associated with some sympathy for the less privileged. In neoliberal economics, the sympathy is entirely for the business classes. Reagan summarized their doctrine best: Government is not the solution; government is the problem.

The neoliberals want as much deregulation of corporations and banks as possible. The markets can regulate themselves. These economists were the advisers for both Republicans and Democrats at the time of the Citibank-Travelers merger — and despite the tremendous blow to that belief in 2008, it remains the predominant theory accepted by the economists who have influence over the government today.

The Three Silos of Stability Maintained in Canada

Canada kept the separation of the three industries. Although the commercial and investment banks were allowed to merge, the assets of the banks were kept as entirely separate entities. Thus, the creditors of the investment banks cannot not seize the deposit money in the commercial banks. It also refused to let banks acquire insurance companies, maintaining that industry separation as well.

The economists who proved that they had no understanding of the financial system prior to 2008 were the ones kept in place to craft the government response and create the convoluted Dodd Frank solution. One section, called the Volcker Rule, attempted a weak version of the Glass-Steagall separation by somewhat limiting the commercial banks power to use deposit money to invest in the markets. It was originally four pages. The banking lobby delayed its implementation for 10 years and obtained pages of exemptions, so it no longer has any effect.

In 2019, Tyler Gellasch, who co-wrote the original version of the Volcker Rule while serving as a top staffer to then-Senator Levin, wrote a tweet declaring the Volcker Rule effectively dead:

“After tens of millions of dollars and a decade of lobbying, the #VolckerRule is a shadow of the original idea and simply no longer works for anyone — it certainly cannot protect the public from another disaster.

What can be done?

In 2012 Steve Denning, writing in Forbes, reported that Sandy Weill, architect of the Citigroup-Traveller merger, saw the error of his ways and surprised financial analysts by “calling for splitting up the commercial banks from the investment banks. He called for the return of the Glass-Steagall Act of 1933, which he said had effectively led to half a century free of financial crises’’.

Weill is correct. The solution is: Revoke the complex 8oo page Dodd Frank, except for the Consumer Financial Protection Bureau, and replace it with the easy to understand four-page Glass-Steagall.

While the separation of the three financial sectors is the foundation for the stability of the Canadian system, that is not sufficient alone to explain its stability. There was another and more important difference: no securitization of residential mortgages in the Canadian system. We will look at the unintended but harmful consequences of the RMBS next.