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July 19, 2010

Smaller as Well as Divided

Justin Katz

It's fortuitous that I'm a bit behind my blogging schedule today, because Marc's closing point happens to relate to my thoughts upon reading Red Jahncke's criticism of the Dodd-Frank Act regulating the finance industry. Jahncke gives a little history:

Under Glass-Steagall, banks were local and regional champions. In New England, for example, Connecticut had Connecticut National Bank and Rhode Island had Fleet Bank. Then, as the states formed regional banking "compacts," New England had Bank of New England and a much-larger Fleet. No matter how well or poorly managed (many failed), these institutions cared. Local and regional bankers knew local and regional businessmen.

Then, in 1994 Congress scrapped state control of interstate banking under Glass-Steagall and allowed nationwide branching. Banks became behemoths with no loyalties and no person-to-person knowledge or understanding of borrowers.

In 1999, Congress repealed the rest of Glass-Steagall, i.e. its separation of commercial and investment banking. And that unleashed huge, highly complex, diversified financial conglomerates -- a very new phenomenon. The short experience with these giants has not been good.

As Anchor Rising readers will surely be able to recite, this is far from the whole story, inasmuch as it was a particular type of asset underlying complex derivatives and forms of investment insurance that catalyzed the collapse. In other words, the bigness and complexity of the banks may have caused problems on their own, but without implicit government backing of — and government incentives for — risky mortgages, investors would not have been as willing to ignore the stability of the table on which the house of cards was being built.

Those tasked with investigating investments — and regulating them, as Jahncke points out — didn't fear the financial structure when they perhaps should have, but they also didn't fear the instability of loans going to people for amounts that they could not afford. Referring back to Marc's post: divided government can, in some instances, get us the least-bad of both sides, but it can also result in a toxic combination, as powerful players find that sweet spot for manipulation in the crack that runs between laissez faire and subsidization.

As for Jahncke's concerns, I'll agree that the Dodd-Frankenstein monster has gone in entirely the wrong direction, essentially writing the problems into the law, and that a different reform could be helpful toward stabilizing the market. But no reform could match a cultural decision that we're all better off knowing our bankers and sticking with those dedicated to our own local markets.