Would ring fencing under Glass Steagall have prevented the 2008 MBS collapse? (Premium)

Last month the Washington Post looked into the contention of the Sanders campaign that Glass Steagall would have prevented commercial banks from crossing the line into the shadow banking realm, and potentially prevented the 2008 economic crisis. The Post article makes a strong case that not only is this not true, but the protective provisions of Glass Steagall were fundamentally irrelevant. What’s the story here?

From the Washington Post Article:

Phillip Wallach, a Brookings Institution fellow and author of “To The Edge: Legality, Legitimacy, and the Responses to the 2008 Financial Crisis,” agreed with that assessment [in reference to and earlier quote in the article]: “Do they think commercial banks couldn’t make mortgages to whomever back under Glass-Steagall? That’s what commercial banks did!  The rise of mortgage-backed securities doesn’t strike me as obviously inconsistent with Glass-Steagall (and obviously took off during the late part of the Glass-Steagall era).” He added: “I think they are stretching very hard to try to fit a square peg in a round hole, and it’s not at all convincing as a matter of accurate historical description.”

Academicians, economists and regulators living and breathing the 2008 crisis have recognized that the heavy reliance of the industry on MBS securities as financing collateral, and the precipitous collapse in their valuation, was the proximate cause of the failure of large institutions. They have also recognized that the generally assumed lack of risk in MBS securities as securities collateral in repo and securities lending represented a colossal systemic “oops” – which in hindsight has exposed significant blind spots within the financial system. It is for this reason that regulators and others reshaping the system have very rightly focused most of their attention on risk recognition, risk management and quality of collateral – as well as systemic transparency that allows participants and regulators to realistically ascertain where and how big the risks are.
Additionally, as the Post points out, the institutions that failed or had to be rescued were not the goliath mixed and merged super entities – they were the traditional investment banks and risk insurers. While Citi – notably – was immensely stressed, it did not in the end fail. So if anything, the mega entities weathered the storm far more successfully than those that existed much as they always had before, during and after Glass Steagall. The real cause of the 2008 disaster was a real estate bubble, plain and simple, a bubble that fully regulated entities performing a traditional banking function in plain sight did much to fuel. It has even been argued that securitization of mortgage repayment risk, and the concentration of that risk into the shadow system – away from commercial banking institutions – did much to limit the damage even as it took down some venerable firms. One of the functions of the shadow banking system has always been to absorb and redirect risks away from the commercial sector. Like it or not, it did its job.
Glass Steagall should be looked at as a model legislative and regulatory approach to dealing with a crisis, but it cannot be factually argued that a return to Glass Steagall is a meaningful response to the actual events leading up to the 2008 collapse. If we want to return to a Glass Steagall-like model for other reasons, that should be a separate conversation. But the system of 2015 is not the system of 1929 – and the problems are much different than those addressed by the 1933 Act.
More importantly, the present political debate bubbling around the topic serves to highlight the far more dangerous problem. It is not a problem of revisionist history or political maneuvering in an election cycle. These are inevitable, and part of the politico-economic process, a reality we need to accept as a price to pay for democracy. No, the real danger is when lawmakers, regulators, participants and the public don’t actually understand the problem. Treating the wrong disease is one good and sure way to kill the patient.
Solid, logical regulation based on accurate understanding of the facts – that encourages systemically useful activity and which penalizes problematic activity – is an absolute positive and welcome good. This approach and thought process behind it is the real and timeless value of Glass Steagall – not the actual legislation itself.

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