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Economy

Breaking up the banks: panacea for the crisis?

The EU wants to reform the banks by separating risky investment activities from everyday banking. The idea, intended to ward off more financial crisis, is actually 80 years old.

In October 1929, the New York stock market crash plunged the American economy into chaos. Within just a few years, the US government had implemented reforms that drastically changed the financial sector. The Banking Act of 1933, otherwise known as the Glass-Steagall Act, introduced the separation of banking activities. It barred commercial banks, which provided clients with normal savings and checking accounts as well as loans, from underwriting stocks and bonds or otherwise dealing in risky investments.

"As early as the 1920s, Senator Carter Glass, one of the authors of the act, believed that too much money was being pumped into speculative investments," says Hans-Joachim Voth, an economic historian at Pompeu Fabre University in Barcelona. "With the Wall Street Crash and the ensuing Depression, Glass saw an opportunity for pushing through a clear separation of commercial banks from investment ones."

Reform fervor back then, a fear of reform now

Black-and-white photos of Senator Carter Glass and US Representative Henry B. Steagall

US Senator Carter Glass and Henry B. Steagall wanted to help end the Great Depression

The Glass-Steagall Act was not the only change made in the US banking sector. The US Securities and Exchange Commission (SEC) was established one year later, in 1934. It continues to enforce federal securities laws and regulate the industry in the United States. The Federal Deposit Insurance Corporation (FDIC), which protects deposits in member banks, was also created at this time.

By contrast, nearly four years after the collapse of Lehman Brothers, politicians have few fundamental reforms they can say will protect future generations. "It's bordering on the criminal that we have not learned one lesson from the crisis [that began in] 2007 and have not really managed to improve regulatory mechanisms," Voth says. "I think it also reflects a failure of intellect." 

The banking business, its complex financial products, its interdependencies with the mainstream economy - Voth believes that all this seems so complex to the politicians that they're afraid of doing something wrong.

"They listen to experts from the financial sector, and then they leave everything the way it was before," he says, explaining that reforms so far have been limited to small changes in the equity rules. "There's no way that's going to enable us to prevent the next crisis."

Above all, the new capital adequacy rules known as Basel III have not even entered into force. In the United States, the attempt to ban banks from speculating on their own account has been postponed for the time being. Britain is planning a series of reforms, but no law is expected before the summer of 2015.

The appeal of the old system

No wonder then that some now wish for a return to the major reform of the past: the separation of commercial and investment banks in 1933. That was finally done away with in 1999 under President Bill Clinton. The decision seemed right at a time in which deregulation was the magic word.

Citigroup Chairman and Chief Executive Officer Sanford I. Weill speaks at a news conference March 20, 2002 in Tokyo, Japan. (Photo by Koichi Kamoshida/Getty Images)

Sanford Weill, the former head of Citigroup, benefited from deregulation but is now believes separation is the better course

Even before 1999, the legal separation of banking had been gradually weakened. Thus in 1998 the financial giant Citigroup, itself the result of a merger, was allowed to own the investment bank Salomon Brothers.

Ironically, Sandy Weill, who was head of Citigroup until the outbreak of the financial crisis and was one of the major beneficiaries of deregulation, is now demanding the reintroduction of the separation between commercial and investment banks. The New York Times, which fought the Glass-Steagall Act for years, is also now a convert. "Having seen the results of this sweeping deregulation, we now think we were wrong to have supported it," the newspaper said in an editorial.

In Germany, Social Democratic Party leader Sigmar Gabriel and Nikolaus von Bomhard, CEO of reinsurer Munich Re, have come out in favor of separating banks. They said there should be no banks that are so important for a country that they need to be rescued with taxpayers' money: "If something is system-relevant, something is wrong with the system," von Bomhard said.

Size isn't everything

However, Georg Fahrenschon, president of the German Savings Bank Association, sees things differently. "I'm not a big fan of a black and white policy that says we should break up the banks and keep them separated," he says.

He defends universal banks that do everything - account keeping, lending, securities trading and foreign exchange transactions. "Over the last three years, we've seen how important it was to have regional banks that could also help mid-sized companies with currency risk management."

Economic historian Hans-Joachim Voth (April 2006) Photo: Werner Baum (c) dpa

Economic historian Hans-Joachim Voth believes banking separation is necessary

Economic historian Voth also says he does not believe that a two-tier banking system would have prevented the financial crisis. But he adds that a separation is necessary to prune banks back to a size that doesn't threaten the entire economy. He points out that until the beginning of liberalization in the 1980s the world managed to get by very well without banks that were "too big to fail," and economic growth was strong.

Voth says the argument that growth was not possible without large international financial groups is a myth. "Nothing that is important to the economy was really worse 20 or 30 years ago. We wouldn't really miss any of the economic functions that investment banks perform today by virtue of their size."

Because of its size Deutsche Bank is also "a risk for Germany that we can actually ill afford to bear," says Voth. "I don't know how many more crises we're going to have to go through before we learn to regulate things well."

However, Europe's politicians are currently primarily engaged in dealing with the debt crisis. "It's a little like reconstructing a ship that's already on the high seas," says the economic historian. Nonetheless, he believes we cannot afford to allow the banks to accumulate more risks which would at some point necessitate the next bailout. It's not a reason to postpone the regulation of the banks, Voth says. "A government has to be able to do more than just keep its eye on the ball and share out the responsibilities."

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