“Secretary Clinton says that Glass-Steagall would not have prevented the financial crisis because shadow banks like AIG and Lehman Brothers, not big commercial banks, were the real culprits. Secretary Clinton is wrong. Shadow banks did gamble recklessly, but where did that money come from? It came from the federally insured bank deposits of big commercial banks — something that would have been banned under the Glass-Steagall Act.”

— Democratic presidential candidate Sen. Bernie Sanders (Vt.), speech on Wall Street and the economy, Jan. 5, 2016

A key dispute between former secretary of state Hillary Clinton and Sen. Bernie Sanders in the race for the Democratic nomination is the role that the partial repeal of Glass-Steagall played in the 2008 financial crisis. Clinton’s husband, of course, in 1999 signed the law that helped break down the walls between investment banking firms and commercial banks.

Our goal here is not to re-litigate the 1999 legislation’s role in the Great Recession. Each side can muster experts to make their case, though in general we would note that few economic crises (like plane crashes) are the result of one single factor; there is a risk in overemphasizing one reason above others. Even Sen. Elizabeth Warren (D-Mass.), who favors reinstalling a version of Glass-Steagall, has acknowledged that crisis probably could not have been avoided if Glass-Steagall had been in place. (The Sanders campaign likes to cite this analysis blaming Glass-Steagall by the regulatory reform group Better Markets.)

So let’s look at Sanders’ specific claim here: That the “shadow banks” got their funds from the “federally insured bank deposits of big commercial banks — something that would have been banned under the Glass-Steagall Act.” Is that correct?

The Facts

Let’s first start with some definitions.

Commercial banks are very visible; they have branches throughout towns and cities, taking deposits and making loans to individuals and businesses. Investment banks are more oriented toward Wall Street, trading securities and raising money for companies through the underwriting of stocks and bonds.

Shadow banks also carry out traditional banking functions, but do so largely outside the purview of bank regulatory systems. The shadow-banking system includes money market funds and off-balance sheet investment vehicles such as collateralized debt obligations and credit default swaps. Another aspect of this market are repurchase agreements, essentially overnight loans for dealers in government securities. The size of the shadow-banking system, which can significantly reduce the cost of credit, has been estimated as high as $67 trillion.

Glass-Steagall, more properly the U.S. Banking Act of 1933, separated commercial and investment banks after the stock market crash of 1929. But provisions of the law had been eroded for many years by regulatory actions before the official prohibition was repealed in the Gramm-Leach-Bliley Act of 1999. Sanders voted against the legislation at the time as a member of Congress.

(Sanders acknowledged that slow erosion in the next line in his speech: “Let’s not forget: President Franklin Roosevelt signed this bill [Glass-Steagall] into law precisely to prevent Wall Street speculators from causing another Great Depression. And, it worked for more than five decades until Wall Street watered it down under President Reagan and killed it under President Clinton.”)

Again, this is what Sanders said: Shadow banks got their funds from the “federally insured bank deposits of big commercial banks — something that would have been banned under the Glass-Steagall Act.”

Warren Gunnels, Sanders’s chief policy aide, explained: “Commercial banks provided the funding to shadow banks in the form of mortgages, repurchase agreements and lines of credit.  Further, commercial banks played a crucial role as buyers and sellers of mortgage-backed securities, credit-default swaps, and other derivatives.  This would not have happened without the watering down of Glass-Steagall in the 1980s and the eventual repeal of Glass-Steagall in 1999.”

But experts generally say this is incorrect.

“Commercial banks could have done all of those things in the 1960s or earlier, even before the Fed and the OCC [Office of the Comptroller of the Currency] and court decisions began to loosen the strictures of Glass-Steagall,” said Lawrence J. White, an expert on financial regulation at New York University’s Stern School of Business.

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: “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.”

However, James G. Rickards, a former general counsel of the hedge fund Long-Term Capital Management and a fierce critic of the 1999 law, says there was an important cultural shift after Glass-Steagall was repealed. Previously, he said, such shadow-bank loans required permission from the Federal Reserve under an application known as 4(c)(8). “The presumption was it was illegal unless the Fed said you can do it,” he said. “After Glass-Steagall, we didn’t have to ask permission, and it enabled the banks to do what they wanted.”

As for Sanders’s specific examples, he mentions Lehman Brothers — an aggressive investment banking firm — and AIG, an insurance company. Their failures were critical to the financial crisis, but neither example necessarily backs up Sanders’s version of history.

The 500-page report of the Financial Crisis Inquiry Commission (FCIC) — the official government-funded investigation of the crisis — said that Lehman relied primarily on non-bank sources of funding, such as money market funds: “Solvency and liquidity were essential and related. If money market funds, hedge funds, and investment banks believed Lehman’s assets were worth less than Lehman’s valuations, they would withdraw funds, demand more collateral, and curtail lending. That could force Lehman to sell its assets at resale prices, wiping out capital and liquidity virtually overnight.”

As for AIG, which required a $180 billion federal bailout, the commission said its “enormous sales of credit default swaps were made without putting up initial collateral, setting aside capital reserves, or hedging its exposure — a profound failure in corporate governance, particularly its risk-management practices.”

Much of its business was conducted in London, and it was under the oversight of a relatively weak regulator, the Office of Thrift Supervision. The FCIC said this was possible because of the deregulation of over-the-counter derivatives the resulted from another law signed by Clinton just weeks before he left office — the Commodity Futures Modernization Act of 2000. (Sanders voted in favor of this law.)

Gunnels said, “I never quite trusted the FCIC. There were dissenting views. We would have had some as well from a much different perspective.” (The dissenting views were all Republican.)

Gunnels also noted reporting that J.P. Morgan Chase, a commercial bank, was the clearing bank for Lehman Brothers and advanced it billions of dollars in credit before it collapsed. (J.P. Morgan Clearing was the remains of Bear Stearns, which the bank acquired in 2008 under the government’s urging to forestall the crisis. J.P. Morgan demanded additional collateral security for clearing activities, putting pressure on Lehman.)

A 2015 report by two Yale University professors who are experts on shadow banking concluded that the “run on repo” was not because of traditional commercial banks but that it “predominantly driven by the flight of foreign financial institutions, domestic and offshore hedge funds, and other unregulated cash pools.”

But experts say that Sanders is not completely off base in his critique of Glass-Steagall. One key player in the crisis was Citicorp, a megabank that was the original impetus for changing the law.

“Citi couldn’t have been like it was in 2008 without Gramm-Leach-Bliley.” Wallach said. “That is the best arrow in the Glass-Steagall revivalists’ quiver. Citibank deposits were attached to Citibank bad investments, and Citi was the Too-Big-To-Fail-iest of them all. Now that’s true enough and has to be behind what Bernie is saying for it to have any force — but of course Bear Stearns … and Lehman … and Merrill Lynch … and Morgan Stanley all managed to get enough funding to be systemically dangerous without the deposit bases, in fact in ways that would have been consistent with Glass-Steagall.”

Former Federal Reserve chairman Paul Volcker, in advocating for what became known as the Volcker rule that limited propriety trading by banks, suggested that eliminating the Glass-Steagall separation of commercial and investment banking allowed for a trading mentality to take hold at some banks.

Camden R. Fine, chief executive of the Independent Community Bankers of America, would not comment specifically on the accuracy of Sanders’s statement. But he noted that Lehman owned a federally insured industrial loan company (ILC) that held insured deposits and that “it was Lehman’s ILC that, in part, gave Lehman the funding liquidity that it needed to buy, package and originate the sub prime mortgages.”

“In my view, he is correct that the repeal of Glass Steagall gave both commercial banks and investment banks who owned ILCs much greater flexibility to deploy their capital and their deposit funds to whatever purposes they wished,” said Fine, who favors a restoration of Glass-Steagall but not Sanders’s specific proposals. “And those firms leveraged themselves many, many multiples of times more than they would have been allowed before the repeal of Glass-Steagall as a result.”

But other experts note that ILC was not what brought Lehman down, but rather it was a fragile balance sheet and bad investments in real estate, leading to demands for increased collateral by lenders.

The Pinocchio Test

We can find little support for Sanders’s statement that Glass-Steagall banned commercial banks from making loans to investment banking firms to facilitate their trading in the shadow-banking arena. Indeed, the two examples he cited did not fail because of loans received by commercial banks, according to the exhaustive government-sponsored investigation of the crisis. Indeed, in the case of AIG, the problems largely stemmed from a law that Sanders himself supported.

On a broader level, Sanders would be on more solid ground to argue that the commingling of investment and commercial banking functions permitted by the 1999 partial repeal allowed the growth of megabanks such as Citigroup that exacerbated the crisis. The observation of Rickards, the former hedge fund general counsel, that such shadow-bank loans routinely required Fed permission before the 1999 law is also instructive — though Rickards also says the 2000 law that Sanders supported was an important factor in the crisis.

We wavered between Two and Three Pinocchio. But this was a prepared — and important — speech by Sanders. So it’s essential to get the facts straight.

Three Pinocchios

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