Helping banks lose their bearings (Newsweek, March 13, 1995)

When it comes to banking and money, the four most dangerous words in the world are, “This time, it’s different.”

Take two of the world’s bigger business stories: the overnight collapse of Barings PLC, the big British banking house, and the current push in Washington to repeal the Glass-Steagall Act of 1933 so that commercial banks and investment-banking houses can poach on each other’s turf without restriction. What do these two events have to do with each other? Simply this: the collapse of Barings, which was done in by a rogue 28-year-old futures trader in Singapore, is living proof of why ending Glass-Steagall could unleash financial disasters that would make the S&L industry collapse look like a wall in the park.

Here’s why. Glass-Steagall separated investment banking and stock brokerage from commercial banking. Investment banks do high-risk, high-profit things like underwriting corporate stocks and bonds, selling securities to investors and wheeling and dealing with their own capital to make a buck. Boring old commercial banks were supposed to merely accept deposits and make loans. Giving up their go-go ways was the sacrifice bankers had to make 60 years ago to get federal insurance of bank deposits.  Hundreds of banks had already failed, and without federal deposit insurance, the nation’s entire financial structure would probably have collapsed. So bankers really had no choice.

Flash-forward to today. Suddenly, it’s become a great time to recombine banking and investment banking. But it’s hard to see why. It wasn’t all that long ago that some of the nation’s largest banks like Citibank were in peril, and big outfits like the Bank of New England closed. Federal Reserve Board chairman Alan Greenspan had to bail out the banks by keeping short-term interest rates artificially low until a year ago. That sharply reduced banks’ borrowing costs and let some of their all-but-dead borrowers come off the slab and live long enough to repay their loans. Now, having avoided mass death only with Greenspan’s help, banks have miraculously gotten smart enough to become big-time investment bankers.

Meanwhile, investment banking, never terribly stable, has gotten crazier than ever thanks to the rise of global trading and derivatives, which have turned money into mere electronic blips on traders’ computer screens. The real Barings lesson isn’t that financial derivatives are the Devil’s plaything. Rather it’s that you can be killed in an eyeblink by a problem you didn’t know you had. A Singapore slinger of futures slips his leash, loses a billion dollars and busts a London institution that had survived 233 years of European turmoil and reported record profits in 1994. You think that commercial-bank companies can cope with this kind of stuff?

Even some of the biggest investment-banking firms are alive only because their owners had deep pockets. Lehman Brothers and Kidder, Peabody would have been long dead without parents like American Express and General Electric, which covered their losses from junk bonds, dumb investments and trading disasters. Prudential Securities, which got burned for selling toxic tax shelters to its customers, would have been buried under a rock long ago without bailouts from Prudential Insurance. Without Credit Suisse pouring in capital, First Boston would have been toast.

Imagine what would have happened if any of these firms had been owned by a bank company that was hit by bad loan problems which occur periodically, like seven-year locusts. The idea that you can combine risky institutions like banks with ultrarisky investment banks and somehow make the world safer for everyone doesn’t make much sense. Especially when you consider that as a group, neither banks nor investment banks have done particularly well in their own businesses. Why should they do better in other businesses?  Besides, financial deregulation tends to have nasty, unintended consequences. Remember how Charles Keating Jr. ran amok in a deregulated S&L? Yes, some Glass-Steagall barriers have broken down over the years, with banks expanding into things like futures trading. But offering unrestricted investment-banking powers to all the nation’s commercial banks is like giving booze to alcoholics. You’re sure to create new drunks.

Financial folly: The Treasury says that “fire walls” will separate commercial-banking companies from investment-banking companies, allowing an investment-banking house to fail without dragging under the commercial bank that’s a sister company. Thus, the deposit-insurance fund and the U.S. taxpayer won’t be exposed to any risk.  Deputy Treasury Secretary Frank Newman says the administration’s main goal in eliminating Glass-Steagall is to let commercial banks peddle corporate bonds and to let investment banks get into commercial banking. Commercial banks, he said, are already allowed to trade the kinds of securities that busted Barings. “Most derivatives activities are already conducted by banks,” he said. The fire walls, he said, will protect us from problems.

Yeah, right. Barings thought it had adequate safeguards. Kidder, Peabody thought so, too, but lost its shirt on mortgage-backed securities and on whatever it was that trader Joseph Jett was doing. Why would federal fire walls, however strong they seem to be on paper, work better than safeguards erected by companies that have their own money at risk?

Forgive my skepticism, but I can’t help hearing the words, “This time, it’s different.” When it comes to financial folly and getting around rules, it’s never different. Make a fire big enough and hot enough, and the Feds’ fire walls will be about as useful as the “watertight bulkhead” that made the Titanic unsinkable.