Former Citibank CEO John Reed Confesses—-Repeal Of Glass-Steagall Was A Mistake

By John Reed at Financial Times

Hardly a week goes by without headlines blaring another restructuring by a big European bank, or the replacement of its management. Deutsche Bank and Barclays are the latest to announce big changes. They follow UBS, Standard Chartered, Royal Bank of Scotland, Credit Suisse and more.

The cause of all this turmoil is the banks’ quest for a formula that will enable them to return to the pre-2008 financial crisis glory days of global reach and big profits. But there is no such formula. The destination will prove unreachable and the quest unfulfilled.

The main reason for this is not that economic growth remains subpar, or that regulation has become more onerous (important though these factors may be). Rather, the trouble stems from a perilous cultural balancing act at the core of European banking: how to manage and profit from their high-risk, high-cost investment banking and trading businesses. In short, the universal banking model is what is really at stake in the search for the right mix of management and operations at banks in Europe and, indeed, in the US.

In America, the universal bank is a relatively new creation. It is 16 years to the day since the Glass-Steagall Act, a law enacted during the Great Depression that had the effect of banning universal banks, was repealed.

Glass-Steagall stipulated that traditional, relatively low-risk banking such as taking deposits and making loans could not be undertaken by the same institutions that were involved in higher risk investment banking activities, such as funding corporate acquisitions and trading securities.

There is an intense debate in the US about whether or not policymakers should adopt a modern Glass-Steagall law, which would effectively end the universal banking model. The question is likely to be a live one in the upcoming presidential election campaign. In answering it, we need to reflect on why Glass-Steagall was repealed and what lessons might guide us as we struggle with the structure of banking in Europe and the US.

Back in 1999, the idea of abolishing the old restrictions had gathered overwhelming momentum. Faith in markets and modern finance was felt not only by the banking industry, but also its customers. They wanted to move beyond straightforward bank borrowing, and tap the capital markets directly — with banks arranging a deal between other market participants, rather than acting as straightforward lenders.

There were new instruments and new opportunities being offered by financial firms that were not available to them from traditional banks. To those customers (and to those of us in the banks), markets seemed more efficient than banks. Transactions would be easier and less costly. What is more, markets could deal with risk by accepting lower or higher returns, whereas banks needed capital to support their lending exposures. Capital markets were also a way to access many other financial institutions and, as a result, a broader array of investors and financial products.

However, we were wrong about some things, and others we failed to anticipate. Two stand out.

One was the belief that combining all types of finance into one institution would drive costs down — and the larger the institution the more efficient it would be. We now know that there are very few cost efficiencies that come from the merger of functions — indeed, there may be none at all. It is possible that combining so much in a single bank makes services more expensive than if they were instead offered by smaller, specialised players.

The second thing we were wrong about has to do with culture — and this turns out to be very serious. Mixing incompatible cultures is a problem all by itself. It makes the entire finance industry more fragile. This is what I mean by an unstable cultural balancing act at the core of universal banking and, the restructurings and management changes we are now seeing in European financial institutions.

As is now clear, traditional banking attracts one kind of talent, which is entirely different from the kinds drawn towards investment banking and trading. Traditional bankers tend to be extroverts, sociable people who are focused on longer term relationships. They are, in many important respects, risk averse. Investment bankers and their traders are more short termist. They are comfortable with, and many even seek out, risk and are more focused on immediate reward. In addition, investment banking organisations tend to organise and focus on products rather than customers. This creates fundamental differences in values.

As I have reflected about the years since 1999, I think the lessons of Glass-Steagall and its repeal suggest that the universal banking model is inherently unstable and unworkable. No amount of restructuring, management change or regulation is ever likely to change that.

Source: We Were Wrong About Universal Banking – Financial Times