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A better way to control the casino

A better way to control the casino
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First Published: Mon, Mar 09 2009. 09 24 PM IST

Updated: Mon, Mar 09 2009. 09 24 PM IST
Why would anybody run a casino and a utility under the same roof? That is the supposedly killer argument of those who want to bring back some variation of the Glass-Steagall Act. This US legislation, brought in during the Great Depression, banned commercial banks from underwriting securities—and led, among other things, to Morgan Stanley being spun off from JPMorgan Chase and Co. It was repealed in 1999.
The idea of forcibly separating utility banking from casino capitalism has superficial attractions. The utilities, which would be tightly regulated, would focus on taking deposits and lending money. The casinos, which would be lightly regulated, could take punts on a whole range of assets.
But Glass-Steagall wouldn’t have stopped the current crisis. For a start, many of the institutions that came a cropper weren’t commercial banks. Lehman Brothers, Bear Stearns and Merrill Lynch were investment banks. American International Group is an insurer. All four caused havoc when they teetered on the brink—or, in Lehman’s case, collapsed. The idea that any institution that is too big to fail should be allowed to operate on a lightly regulated basis is surely wrong.
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Now, of course, lots of commercial banks have got into trouble, too. Think of Citigroup or, across the Atlantic, Royal Bank of Scotland or Switzerland’s UBS. Part of the reason was that they invested in toxic securities. So it’s appealing to think that they, at least, would have been safe if only they hadn’t mingled the casino with the utility.
But this again oversimplifies the issue. True, these “universal” banks lost money in the casino. But they also lost pots of cash through straightforward bad lending. And there are plenty of other simple utility-like financial institutions that got into trouble: Fannie Mae, Freddie Mac, the UK’s Northern Rock, Countrywide Financial, Washington Mutual and Wachovia.
So, yes, the casino is risky. But so is the utility. What the current crisis has shown is that the management of risk has been woeful right across the board.
The solution then isn’t to pick on one particular banking activity, label that as especially risky and quarantine it in some half-regulated purgatory. The better approach is to improve risk management across the industry.
Multiple changes are required to achieve this. But an essential element also has to be a regulatory system that requires banks to hold fatter capital buffers the bigger the risks they run. That won’t just stop them from going bust. It will also discourage them from running too many risks in the first place.
Such tighter regulation has to be the quid pro quo for being allowed to take deposits from the public or for being too big to fail. When banks take deposits, governments stand behind them with guarantees. If they are too big to fail, the taxpayer stands ready to bail them out. Whether they are commercial banks or investment banks is largely irrelevant.
But there is one dividing line that is worth drawing: between institutions that enjoy the full panoply of government protection and those that don’t. Hedge funds and private equity firms should fall into the latter category. They don’t themselves need to be tightly regulated.
Rather, the interface between them and banks needs to be closely monitored, so that banks don’t extend them too much credit. If they go bust, they won’t then drag the banking system down with them. If some people think of that kind of divide as a new version of Glass-Steagall, so be it.
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First Published: Mon, Mar 09 2009. 09 24 PM IST