Congress is trying to limit what investments banks can make. Half-baked bureaucratic interference will make the financial sector more volatile.
Some politicians don’t understand why diversification makes portfolios less risky. Any investment adviser worth his salt will recommend clients hold a diversified portfolio that includes stocks as well as bonds. On Capitol Hill, however, Sen. Maria Cantwell, Washington Democrat, and Sen. John McCain, Arizona Republican, are proposing to reinstate the Glass-Steagall Act, which would undo one of the more sensible policies of the Clinton administration. Repealing that act in 1999 allowed commercial banks to diversify into stocks.
If the Glass-Steagall Act hadn’t been rescinded, the recent financial mess would have been a lot worse. A useful example is how Fannie Mae and Freddie Mac mislabeled mortgages they bundled together, telling investors that certain mortgages were AAA which in fact were subprime. It’s not difficult to understand that damage would have been far worse if banks had only been able to invest their money in these mislabeled mortgages. Being able to diversify their holdings mitigated for at least some of these disastrous mortgages.
Over the last decade, the government has taken many actions to increase the riskiness of banks. The Federal Reserve forces banks to make loans to individuals who don’t have the income to pay them back or forces banks to give out loans with little or no down payments. Both obviously increase the riskiness of mortgages.
Over time, some regulations that made banks especially risky have been removed. Forty or 50 years ago, many states still limited banks to only one office. At the time, banks primarily held mortgages in their local areas. If the local factory closed, property values fell and the bank risked failure. Letting banks hold mortgages from all across the country eliminated some risk by spreading it out geographically. Diversification means a bank’s eggs aren’t all in one basket. It makes no more sense today to limit banks to one type of investment or one type of business than limiting their holdings to local mortgages did in the old days.
Mr. McCain and Ms. Cantwell claim their bill is motivated by banks being “too big to fail.” In other words, they claim that if Congress limits what banks can do, banks will be smaller and thus purportedly would cause less systemic damage if they go belly up. But limiting what assets banks can hold is completely different than limits on how large they can be. The senators will just produce riskier banks whatever size they end up being.
We don’t think banks or financial institutions should be bailed out, no matter the size. The Federal Deposit Insurance Corporation must do a much better job of charging banks insurance premiums that properly reflect the riskiness of their assets. Ideally, it would be healthier to move towards a private system of insurance that would properly price risk, but we live in an age shorn of idealism.
The answer to the fallout from bad government is not more red tape. Federal regulations are responsible for serious damage that already has been done to financial markets. Unless government accepts responsibility for making banks risky and curtails its meddling in business decisions, America will face more serious financial crises in the future.