What liberals get wrong when they only focus on breaking up the big banks

U.S. Democratic presidential candidate Bernie Sanders. (Reuters/Chris Keane)

It can't be a coincidence that a decade after we got rid of our Depression-era banking protections, we got our worst banking crisis since the Depression — can it?

That, more or less, is the argument that Democratic presidential candidate Bernie Sanders has made about bringing back the Glass-Steagall Act. That would break up the big banks by preventing ones that take in deposits from getting into riskier businesses such as selling securities, underwriting IPOs or trading for their own account. In other words, it would separate Main Street banking from Wall Street banking. Indeed, that had been the law of the land until the 1990s, when, in a fit of deregulatory zeal, it was first weakened and then abolished altogether. The result was banking behemoths like Citigroup that wasted no time taking risks they didn't understand.

The question, though, isn't whether reviving Glass-Steagall makes sense — it does — but whether it makes more sense than the alternatives. And the answer is probably not.

Now, it's true that if your goal is just breaking up the big banks, there are a lot worse ways to do it than splitting them into separate businesses. But that's not because that would make them small enough to fail. As Long-Term Capital Management showed in 1998, even something as small as a hedge fund can potentially bring down the financial system if it's interconnected enough. No, it's because the JPMorgans of the world might have gotten too big to manage. Even the best run of them can't avoid the occasional $6.2 billion loss when they have so many businesses to keep track of. Not only that, but having their fingers in not just a lot of financial pies but actually all of them can create all kinds of conflicts of interest. Suppose a bank is helping a company sell some of its shares. What will the bank's analysts tell its customers to buy? There's supposed to be a "Chinese wall" between the different parts of the bank, but at least during the tech bubble, this worked about as well as the actual one did at keeping out the Mongols — which is to say, not at all.

In other words, big banks have real costs and Glass-Steagall could do something about them. But are there any benefits? Well, not according to former Citigroup chief executive John Reed. "We now know that there are very few cost efficiencies that come from the merger of functions," he recently wrote, and "indeed, there may be none at all."

But just because Glass-Steagall might make the banks better doesn't mean that it would make it any safer — and that should be our priority. After all, banks got into all the trouble they did by making bad loans that they still could have if Glass-Steagall had been around. So what would help more? Well, the crisis revealed three big problems in our financial system. First, so-called shadow banks weren't safe from runs. Second, actual banks didn't have enough capital to be safe enough. And third, too many derivatives weren't regulated at all. Put those all together, and we had a financial system that was just waiting to collapse. All it took was people not being able to tell how much money they or anyone else had lost to start a run where the financial system didn't have any safeguards, which, by the time it reached the parts that did, was too big to stop with anything other than a bailout.

The good news is that the Dodd-Frank financial reform really did fix some of this. It requires the big banks to hold more capital and forced derivatives to be traded on exchanges where risks can be seen. But the bad news is that it still leaves the shadow banking system susceptible to runs. Now wait a minute. What exactly is a "shadow bank"? The answer isn't as, well, scary as it sounds. It's just an unregulated lender — maybe a money market fund or a hedge fund or an off-balance-sheet entity — that borrows short and lends long like a regular bank does. But because they don't follow the rules that banks do, they don't get the protections that banks do. That means they don't have the benefit of deposit insurance or the ability to borrow from the Federal Reserve in an emergency. So the result is that shadow banks are inherently vulnerable to runs. The only thing we have done about that is tell the shadow banks that they can stop people from pulling their money out during a run. Maybe that's enough, but maybe it's not.

Again, this has nothing to do with Glass-Steagall. That would just split big unsafe banks into slightly smaller unsafe banks. But it wouldn't create a financial safety net where we don't have one or strengthen it where we do — which is what we need. Instead, as the Roosevelt Institute's Mike Konczal argues, we should try to do more of what Dodd-Frank does well. That might mean saying, even more than we already have, that the bigger the bank, the bigger the capital requirement, so that they break themselves up like GE did when it sold GE Capital. Or it might mean increasing capital requirements for riskier types of businesses to try to get them to break themselves up that way. Or, in what would be a much more radical step, creating some kind of deposit insurance for the biggest kind of shadow banks.

Glass-Steagall has become a kind of litmus test for who's tough on Wall Street and who's not. That is a mistake. You don't have to do exactly what FDR did to be as hard on the big banks as he was.