More Banking Mystifications

By James Kwak

Apparently, both parties have platform planks calling for the reinstatement of the Glass-Steagall Act of 1933, the law that separated investment banking from commercial banking until it was finally repealed in 1999 (after being watered down by the Federal Reserve beginning in the late 1980s). Bringing back Glass-Steagall in some form would force megabanks like JPMorgan Chase, Citigroup, and Bank of America to split up; it would also force Goldman Sachs to get rid of the retail banking operations it started in a bid to get access to cheap deposits.

In his article discussing this possibility, Andrew Ross Sorkin of the Times slips in this:

“Whether reinstating the law is good idea or not, the short-term implications are decidedly negative: It would most likely mean a loss of jobs as part of a slowdown in lending from the biggest banks.”

I looked down to the next paragraph for the explanation, but he had already moved on to another unsubstantiated claim (that the U.S. banking industry would be at a competitive disadvantage). So, I thought, maybe it’s so obvious that Glass-Steagall would reduce lending that Sorkin didn’t think it was worth explaining. I thought about that for a while. I couldn’t see it.

In fact, basic intuitions about finance indicate that Glass-Steagall should have no effect on lending whatsoever. Banks should loan money to borrowers who are good risks: that is, those who pay an interest rate that more than compensates for the risk of default. (I’m simplifying a bit, but the details aren’t relevant.) Common sense tells you that whether the bank doing the lending is affiliated with an investment bank shouldn’t make a difference.

To dig a little deeper, banks should be making loans whose expected returns exceed the appropriate cost of capital. So, maybe Sorkin thinks that grafting an investment bank onto a commercial bank will lower its cost of capital. I can’t think of any obvious reason why this should be the case. Even if it does, however, we do NOT want the commercial bank to now start making more loans than it did before it was affiliated with the investment bank. Capital markets are supposed to direct funds to households and companies that can put them to their best use. Whether X (a house, a shopping mall, a factory, whatever) is a good use of capital does not depend whether some bank merged with some other bank. If a lower cost of capital causes banks to start making more loans, those are bad loans, not good ones.

Let’s look at this from another angle. Assume Commercial Bank has a cost of capital of 10% and Investment Bank has a cost of capital of 8%. (In practice it’s usually the other way around, but then the argument for a combination is even weaker.) Say they merge, and new Universal Bank has an overall cost of capital of 9%. This does not mean that the appropriate cost of capital for Commercial Bank (a subsidiary of Universal Bank) is now 9%. It’s still 10%. That’s because the cost of capital is based on the risk profile of a company’s business—and, once again, that business hasn’t changed. And, indeed, even after the merger, Commercial Bank and Investment Bank will continue to be run as two separate entities, with a few specific touchpoints (e.g., Commercial Bank will sell its loans to Investment Bank to be securitized, and Investment Bank will try to sell wealth management services to Commercial Bank’s customers). And in the executive suite, the CFO and treasurer will charge an internal cost of capital to each business, based on its intrinsic attributes.

Now, maybe Commercial Bank will want to issue more loans because Investment Bank wants to securitize them. (Does this story sound familiar?) But first, this shouldn’t happen. If demand from Investment Bank is causing Commercial Bank to increase its lending, then that should happen whether or not they happen to have the same parent (Universal Bank); Commercial Bank can already sell its loans to Investment Bank (or any of its competitors) without a merger. Second, even if it does happen—because, say, the CEO of Universal Bank orders Commercial Bank to increase its lending—those are loans we don’t want to exist. There is such a thing as too much credit, as we all should remember.

In sum, the idea that separating commercial and investment banking will result in fewer loans, and hence higher unemployment, seems like another of those industry talking points that, repeated often enough, become conventional wisdom. It’s one of those threats bankers like to make when politicians try to shrink their empires: Come after my bank, and look what happens to your economy. But in this case, it’s an empty threat.

11 responses to “More Banking Mystifications

  1. I think the fact that the banks have to charge such outlandish credit interest rates now (I mean they borrow it for nothing yet the rate only rises when the rate rises, it never goes down when the borrowing cost go down) to recoup bad past business practices, shows just how irresponsible banking has gotten over the past few decades.
    Where has the guy who is trying to reduce the cost of living and banking gone too? Sorkin, any answers??
    Never mind.
    Don’t pass go, don’t collect $200, just go straight to hell in a hand basket is prolly the answer.

  2. David Laurence

    There’s much talk about “fintech” companies disrupting the existing financial system – disintermediation I think is the word du jour. I’d be interested in your thoughts.

  3. In principle, a diversified business line is beneficial to all stakeholders (including customers). A higher-performing business line can subsidize an underperforming one. This works particularly well if the business lines are cyclical and uncorrelated (or better yet, negatively correlated).
    Problems with applying this reasoning to banking are many, here are a few:
    * I-banking and C-banking are generally not uncorrelated
    * No one thinks bank management isn’t just going to pocket the surplus profits from the outperforming business line and let the public subsidize the underperforming one
    * It isn’t the argument industry proponents are making in any case (Sorkin evidently isn’t even making an argument)

  4. Come on ! It’s Sorkin. No need to explain anything.
    It’s his method for maintaning self-sustainability.
    Yeah, like you said……..
    The even-more-ignorant punditry will be quoting Sorkin against the ‘big-deal’ Glass Steagall re-do.

    The only potentially valid point I can think of is whether the commercial bank deposit insurance crutch is a factor in determining the risk-averse profile of the whole integrated bankcorp. It probably does. But that still leaves all creditworthy borrowers with a source for lending, just that a few on the edge might get outside the new risk-curve for the stand alone IB.

    The bigger question is what do we seek to ‘gain’ from the G-S revisit(?) .
    The captured regulators will still be allowing the CBs to take on systemic risk, based on their own risk profiles, which risk consideration does not include damage to the real economy from banking system losses.

    There IS a problem with our Money and Banking System that G-S does not repair.
    http://econintersect.com/pages/opinion/opinion.php?post=201606190011

    Just saying.
    For the Money System Common

  5. BRUCE E. WOYCH

    @Joe Bongiovanni : It is good to see that someone is not being suckered in by a insider poster boy for wall street and the big banks. Sorkin is not an intellectual, he is a born and bred troll and mouth piece for big money and covers their tracks as much as he spends time spreading disinformation to the uninformed. It is very unfortunate that he can create an actual discussion out of his deception and make it look like economic reasoning.

  6. BRUCE E. WOYCH

    “The two overarching questions now are whether the effort to restore the Glass-Steagall Act will come in time to prevent another epic crash of the banks or if there will be soiled, invisible hands working at the upcoming Democratic Platform meeting in Orlando, Florida on July 8-9 to gut the Glass-Steagall amendment from the party platform before the full Platform Committee votes.”
    (excerpted from: http://wallstreetonparade.com/2016/06/as-big-banks-hemorrhage-capital-glass-steagall-is-quietly-added-to-democratic-platform/ As Big Banks Hemorrhage Capital, Glass-Steagall Is Quietly Added to Democratic Platform: WALL STREETON PARADE
    By Pam Martens and Russ Martens: June 28, 2016

  7. Was there a consensus to gut during the meeting on those two dates Bruce? Or should we just break out the knives and start, excerpting?

  8. Mystical math – the financialization of organic intelligent life with the goal of creating artificial intelligence – the “middle man” schtick clearly has hog-tied commerce – the CONSUMER wants it, right? 18 TRILLION $$ economy producing 37K NEW jobs….? Wait, Uber jobs are not “new”, they are created by destroying established full time transportation jobs….mystical Nihilism….mystical math….MYTHICAL conclusions

    Has Trump ever used psychics as a “decider”….? We know that Presidents are required to follow the plans of the Voice in the Garden – or else…looks like Warren has her loved ones under the knife – no other explanation for the character change:

    http://www.cnbc.com/2016/07/26/elizabeth-warren-party-girl-or-patsy-commentary.html

    Crimes against Humanity….what happens when humans decide there is no such crime as a crime against humanity…?

    http://news.bbc.co.uk/2/hi/uk_news/7351199.stm

  9. Sanity test – if you did NOT laugh at my speculation – whether Trump will be using “psychics” to rule the world – then you need to stop binge watching “Game of Thrones”…

    The only “thing” standing between swift and immediate justice and the containment of Crimes Against Humanity launched by Global War Drug and Slave Lords is…..

    drum roll please….

    their sycophant “religionists”….

    Yup, “religion” is working for the Devil. Go figure, “who’s your daddy….”?

    188:4.8 (2017.3) When once you grasp the idea of God as a true and loving Father, the only concept which Jesus ever taught, you must forthwith, in all consistency, utterly abandon all those primitive notions about God as an offended monarch, a stern and all-powerful ruler whose chief delight is to detect his subjects in wrongdoing and to see that they are adequately punished, unless some being almost equal to himself should volunteer to suffer for them, to die as a substitute and in their stead. The whole idea of ransom and atonement is incompatible with the concept of God as it was taught and exemplified by Jesus of Nazareth. The infinite love of God is not secondary to anything in the divine nature.

  10. James, could you explain for those of us not hip to finance what a bank’s cost of capital refers to? Does this reference the interest rate paid to depositors? Or the default rate on its loans? Something else? Thanks!