Influential voices in the U.S. and the U.K. are calling for strong regulation of the banking system of the kind that the Glass-Steagall Act of 1933 implied.

With the worst economic downturn since the Great Depression having been stalled and partially reversed, the pressure to rein in unfettered finance, which generated the 2008 crisis, has eased. Moreover, with no agreement on the nature and extent of re-regulation of finance that is required, the debate goes on but little is actually being done to reform the financial system. There are, however, radical recommendations which are being advanced, even if by a minority. One such is the demand for a reinstatement of the regulatory structure shaped in the United States by the Glass-Steagall Act of 1933. This regulatory framework was diluted over a long period starting in the 1980s and finally dismantled through the Gramm-Leach-Bliley (or Financial Services Modernization) Act of 1999, paving the way for financial innovation and proliferation.

The regulatory framework that Glass-Steagall defined (and served the U.S. well for more than four decades) was necessitated by the crisis that engulfed the free banking regime in that country in the early 20th century. During 1930-32 alone, more than 5000 commercial banks accounting for about a fifth of all banking institutions in the U.S. suspended operations and in many cases subsequently failed.

Underlying the 1930s crisis was the competition that characterised the free banking era in which interest rate competition to attract deposits necessitated, in turn, investment in risky, high-return areas. This soon showed up in a high degree of financial fragility and almost routine bank closures. The Banking Act of 1933 limited competition with deposit insurance, interest rate regulation, and entry barriers which together rendered any bank as good as any other in the eyes of the ordinary depositor. This preempted the tendency to push up deposit rates to attract depositors that would require risky lending and investment to match returns with costs. The regulatory framework went even further to curb risky practices in the banking industry. Restrictions were imposed on investments that banks or their affiliates could make, limiting their activities to provision of loans and purchases of government securities. There was a ban on banks underwriting securities and serving as insurance underwriters or agents, besides limits on outstanding exposure to a single borrower and lending to sensitive sectors like real estate.

Even though this regulatory framework was directed at and imposed principally on the banking sector, it implicitly regulated the non-bank financial sector as well. It is not often recognised that the size, degree of diversification and level of activity of the non-bank financial sector depends on the degree to which institutions in that sector can leverage their activity with credit delivered directly or indirectly from the banking system. Banks being the principal depository institutions are the first port of call for a nation's savings. So if direct or indirect bank involvement in a range of non-bank financial activities was prohibited, as was true under Glass-Steagall, then the range and scope of those activities are bound to be limited. Not surprisingly, right through the period of intensive regulation of the financial sector in the U.S., there was little financial "innovation" in terms of new institutions or instruments, though there were periods characterised by substantial and rapid growth in the financial sector. In the event, even by the 1950s, banking activity constituted 80-90 per cent of that in the financial sector and trading on the New York Stock Exchange involved a daily average of three million shares at its peak as compared with as much as 160 million shares per day during the second half of the 1980s, when leverage became possible.

The process of dismantling the Chinese Walls separating different segments of the financial sector began in 1982, when the Office of the Comptroller of Currency permitted several banks to set up subsidiaries to engage in the discount brokerage business. Since then the process has continued. Bank holding companies were allowed to underwrite commercial paper, municipal revenue bonds, mortgage- and consumer loan-backed securities, and corporate bonds and equities through securities subsidiaries. It was this new framework that Gramm-Leach-Bliley legalised in 1999.

The liberalisation encouraged banks to expand into areas and transform the nature of their intermediation activity. While banks did provide credit and create assets that promised a stream of incomes into the future, they did not hold those assets any more. Rather they structured them into pools, "securitised" those pools, and sold these securities for a fee to institutional investors and portfolio managers. Banks transferred the risk for a fee, and those who bought into the risk looked to the returns they would earn in the long term. The net result was an era of financial innovation that created products like "collateralised debt obligations" and "credit default swaps" that were the derivatives that exploded and precipitated a financial crisis.

That the complex structure which delivered extremely high profits to the financial sector was prone to failure has been clear for some time. For example, the number of bank failures in the United States increased after the 1980s. During 1955-81, failures of U.S. banks averaged 5.3 per year, excluding banks kept from going under by official open-bank assistance. On the other hand, during 1982-90 failures averaged 131.4 per year or 25 times as many as 1955-81. During the four years ending 1990, failures averaged 187.3 per year. The most spectacular set of failures, was that associated with the Savings and Loan crisis, which was precipitated by financial behaviour induced by liberalisation. Finally, the collapse of Long Term Capital Management pointed to the dangers of leveraged speculation. Each time a mini-crisis occurred there were calls for a reversal of liberalisation and increased regulation. But financial interests that had become extremely powerful and had come to control the U.S. Treasury managed to stave off criticism, stall any reversal and even ensure further liberalisation. The view that had come to dominate the debate was that the financial sector had become too complex to be regulated from outside; what was needed was self-regulation.

Underlying the current crisis too were two consequences of the developments outlined above. First, the "originate-and-distribute" model migrated out of the banking system to other segments of the financial sector. Second, this was facilitated by the fact that in more ways than one this resulting diversification and proliferation of Finance, was leveraged by the liberalised banking system. Because of this complex chain, institutions at every level assumed that they were not carrying risk or were insured against it. However, risk does not go away, but resides somewhere in the system. And given financial integration, each firm was exposed to many markets and most firms were exposed to each other as lenders, investors or borrowers. Any failure would have a domino effect that would damage different firms to different extents.

Not surprisingly, in the wake of the crisis, John McCain, the Republican senator for Arizona, and Maria Cantwell, the Democratic senator for Washington state, have (last month) introduced a bill to restore the Glass-Steagall Act. But it is not just this political move that keeps the issue on the table. On a number of occasions Paul Volcker, former chairman of the Federal Reserve has called for a new version of Glass-Steagall and a return to "narrow banking". And Mervyn King, the governor of the Bank of England has joined the chorus with a call for "utility banking" that restricts banks to the tasks of financial intermediation and payments facilitation, and disallows speculative investments. Volcker has also argued that there was no neutral evidence whatsoever that financial innovation improves economic growth. The image and track record of these central bankers gives the demand for a return to Glass-Steagall much credibility.

Needless to say, bankers have been quick to protest, since this would not merely restrict their freedom to do "God's work" (as Lloyd Blankfein of Goldman Sachs put it), but also limit the profits on which their bonuses depend. But as Simon Johnson, a former chief economist at the International Monetary Fund reportedly queried: "If independent experts told Congress there was a really dangerous nuclear plant that could blow up in the next 25 years, then lawmakers wouldn't take objections from the nuclear industry very seriously. So why are we only going to Wall Street for expert advice on how to re-regulate Wall Street?" Unfortunately, as of now, financial policy is still influenced by big finance, limiting progress in a policy area that needs urgent action.

More In: Lead | Opinion