The White House and lawmakers want to reinstate a 1930s law they don’t understand

In recent months, the Trump administration and members of Congress have called for reinstating the Glass-Steagall Act, a Depression-era law that separated commercial banking from investment banking. That would be a serious mistake. Instead, Congress should repeal the Dodd-Frank financial reform’s “Hotel California” provision, which prevents large banks from voluntarily separating their commercial and investment banking activities.

The biggest problem with the calls for the reinstatement of Glass-Steagall is a lack of understanding about Glass-Steagall itself.

Gary Cohn, director of President Trump’s National Economic Council, has in the name of Glass-Steagall called for treating large banks and small banks differently. A good idea, but nothing to do with Glass-Steagall. Treasury Secretary Steven Mnuchin has called for a 21st Century Glass-Steagall Act, but he has not specified what that means. And Sen. Elizabeth Warren (D-Mass.) recently asserted that a reinstatement of Glass-Steagall must completely separate commercial banking (accepting deposits and making loans) from investment banking (trading securities and helping companies raise capital), just like the orginal act did. Only it didn’t.

It is time to clear the air. The Glass-Steagall Act prohibited commercial banks from engaging in investment banking activities and vice-versa. Therefore, commercial banks could not underwrite certain securities, and investment banks could not take customer deposits. These laws remain in effect today. There is no need to bring them back.

The Glass-Steagall Act also prohibited commercial banks from affiliating with firms “principally engaged” in investment banking. In practice, this meant that there was very little affiliation between commercial banks and investment banks from the 1930s until the 1980s. But in the 1980s and 1990s, the Federal Reserve interpreted “principally engaged” to allow for affiliates of commercial banks to derive 10 percent, and eventually 25 percent, of revenue from investment banking. So, the affiliation of commercial banks with entities engaged in investment banking became common under Glass-Steagall itself.

Then, in 1999, the Gramm-Leach-Bliley Act (GLBA), which was championed by then-Treasury Secretary Lawrence Summers and signed into law by President Bill Clinton, repealed the Glass-Steagall Act’s restrictions on affiliation. The GLBA received widespread bipartisan support because it put the U.S. banking system on more equal footing with foreign competitors not subject to such restrictions.

However, the GLBA has received much of the blame for the 2008 financial crisis, and therefore many critics, including Warren and Sen. John McCain (R-Ariz.), argue that we should reintroduce Glass-Steagall. In April, they and other senators introduced the 21st Century Glass-Steagall Act, which would prohibit any affiliation between commercial banking and investment banking, thus going even further than Glass-Steagall itself.

But these calls for reinstating the repealed portions of the Glass-Steagall Act are misplaced — because the GLBA did not cause the financial crisis.

The financial crisis was caused by a bubble in residential and commercial mortgages that led to a widespread run on the global financial system. The securitization of mortgages (packaging mortgages into mortgage-backed securities) increased the size of the bubble through an opaque and often conflicted process. Ultimately, governments from across the world had to step in. But what does this have to do with the affiliation of commercial and investment banks? The answer is nothing.

The largest failure during the financial crisis was of a stand-alone investment bank, Lehman Brothers, that did not have significant commercial banking operations. The largest commercial banks that failed, including Washington Mutual and IndyMac, did not have any significant investment banking activities. AIG, which received $182 billion in government support, was a thrift holding company, and thrifts had always been exempt from the Glass-Steagall Act’s restrictions.

Which, finally, brings us to “Hotel California.” Oddly, while there are calls to mandate the complete separation of commercial banking from investment banking, there are no calls from Glass-Steagall champions to eliminate this Dodd-Frank provision, so dubbed for the well-known Eagles’ lyric, “You can check-out any time you like, but you can never leave.”

Hotel California applies to commercial banking organizations that received Troubled Asset Relief Program (TARP) assistance and have more than $50 billion of assets. It prevents these banks from spinning off their investment-banking activities by deeming such an entity a “non-bank systemically important financial institution” subject to enhanced regulatory scrutiny, including significantly higher capital requirements.

Currently, Hotel California applies to 65 percent of U.S. banking assets, so eliminating it could significantly reduce the concentration and complexity of U.S. banking organizations. Activist shareholders could once again press large commercial banks to simplify if they think this would enhance their overall profitability — on a “too big to manage” rationale. Senior management of former investment banks, such as Goldman Sachs and Morgan Stanley, might be inclined to separate their investment and commercial banking operations given the relative unimportance of deposit-taking to their overall operations.

Fortunately, repeal of Hotel California passed the House in June as part of the Financial CHOICE Act. The Senate should follow suit. Congress should therefore seriously consider empowering the management and shareholders of the largest U.S. banks, rather than mandating a wholesale redesign of the U.S. financial system based on a misunderstanding of a 1930s law and its role in the 2008 financial crisis.