Clinton and Summers are wrong on Sanders’s Glass-Steagall proposal

Sen. Bernie Sanders (I-Vt.), along with Sens. Elizabeth Warren (D-Mass.), John McCain (R-Ariz.) and others, has called for the passage of an updated version of the Glass-Steagall Act in our nation’s next round of financial reforms. Sanders’s rival for the Democratic nomination, former Secretary of State Hillary Clinton, joined by her husband’s former Treasury secretary, Larry Summers, objects to this proposal (although both make constructive proposals of their own). Her professed ground is that the original Glass-Steagall Act wouldn’t have prevented our most recent crisis, which was caused mainly by shadow banking. This is a bit like objecting to the iPhone 6s because your flip phone had inadequate functionality. It suggests incomprehension of Sanders’s, Warren’s and McCain’s proposals, for the whole point of these proposals is to regulate 21st-century shadow banking just as the original Glass-Steagall regulated 20th-century shadow banking.

{mosads}So what is shadow banking? “Shadow banking” refers to the performance of risky bank-like functions by institutions that are not as carefully regulated as banks. The most dangerous such function is that of borrowing short-term in order to invest in longer-term financial instruments, all while hoping that you will be able to “roll over” — renew or refinance — your short-term loans over the durations of those longer-term investments. When you can do that, you can make a great deal of money by investing in higher-end speculative financial instruments, because short-term borrowing costs are lower than long-term speculative yields. But you also put those who lend to you — notably bank depositors or counterpart small savers (more on them, below) — at great risk, for you’re engaged in a “musical chairs” form of finance: You avoid bankrupting yourself and your lenders only as long as your speculative investments keep rising, bubble-fashion, in price.

During the 1920s, in the lead-up to the great crash of 1929, shadow banking occurred largely through the relations between depository institutions of the kind in which most working Americans kept their money, and high-end securities firms — firms like today’s J.P. Morgan and Goldman Sachs — through which mainly the rich invested. Securities firms borrowed short-term from depositories — hence from their depositors — then used the borrowings to purchase high-yield speculative financial products. The result was first a bubble-inflating binge of speculative buying of such products, then the massive failure of both the securities firms that bought them and the banks and depositors who lent the short-term money once the bubble had burst. For this reason, the Glass-Steagalll Act, passed shortly after the 1929 crash in 1933, put an end to these relations between depository institutions and securities firms. It ended, in other words, the 1920s version of shadow banking.

The 21st-century version of Glass-Steagall advocated by Sanders, Warren, McCain and others aims at today’s versions of shadow banking: The versions highlighted by the 2008 crash.

What are those? Well, there are a number of them, but the basic idea can be illustrated clearly enough through one typical example: In the lead-up to 2008, many working Americans had come to hold money in so-called “money market mutual funds” (MMMFs). These funds were designed to look and act like bank accounts: one share was valued at one dollar, you could write checks and use payment cards on your accounts with them, etc. Problem was, these bank imitators were not carefully regulated as banks. Indeed, they acted much as banks had done prior to the 1929 crash and the first Glass-Steagall Act: They made short-term loans to securities firms and other high-flying financial institutions — firms like Bear Sterns and Lehman Brothers — that used short-term borrowed funds to make highly speculative investments in bad mortgage products and other high-risk financial instruments. The results were predictable and catastrophic: In essence, a replay of the Wall Street binge of the 1920s, culminating in a crash much like that of 1929.

Now, as noted above, there are other shadow banking activities additional to those of MMMFs — derivatives writing and trading, for example, like that done by AIG before 2008, and speculative (not to mention exploitative) securitizable mortgage lending like that done by Countrywide in the same period. Moreover, many of the most dangerous shadow banking operations were — and still are — conducted by institutions that are affiliated with ordinary depository institutions under single holding company structures, structures that the original Glass-Steagall Act prohibited and which President Bill Clinton and Secretary Summers pushed to allow. For precisely these reasons, the updated Glass-Steagall proposals pushed by Sanders, Warren, McCain and others is a 21st-century Glass-Steagall, designed to end or to regulate today’s shadow banking and conglomeration just as the original Glass-Steagall ended the last century’s shadow banking and conglomeration.

Against this backdrop, it is surprising to hear Clinton and Summers attacking proposals like those of Sanders, Warren and McCain on grounds that last century’s Glass-Steagall wouldn’t prevent this century’s crises. That the 1930s Glass-Steagall wouldn’t be enough today is precisely the point: It is why Sanders, Warren, McCain and others are calling for a 21st-century Glass-Steagall — for an iPhone 6s, if you will, instead of a flip phone. Today’s (not yesterday’s) forms of shadow banking, in other words, are precisely what prompt these proposals.

If Hillary Clinton and Larry Summers are serious, then, in claiming that the Glass-Steagall Act of 1933 was not sufficient to address the shadow banking of 2008 or today, then they should join Sen. Sanders in — and not attack him for — advocating a Glass-Steagall fit for the today. To do otherwise is simply to play Wall Street’s tune while pretending to play Main Street’s tune — yet again.

Hockett is Edward Cornell Professor of Law at Cornell University, a fellow at the Century Foundation and senior counsel at Westwood Capital Holdings, LLC.