Back to the future with Glass-Steagall?

Top officials in the UK are discussing whether regulatory reform in that country should include some sort of separation of commercial and investment banking as the United States had under the Glass-Steagall Act.

While several members of Congress in the U.S. have decried the repeal of Glass-Steagall a decade ago and urged its restoration, neither the administration nor the Federal Reserve have suggested that such a separation will be part of reform efforts in this country.

The Glass-Steagall Act was passed in the wake of the Great Depression because it was felt that abuses and conflicts of interest from having securities and lending under the same roof contributed to the economic collapse.

The separation lasted until the 1990s, after money-center banks were allowed to cross state lines and grow to a size that made them seek diversification through combining commercial and investment banking. The Glass-Steagall separation gradually crumbled until the Gramm-Leach-Bliley Act in 1999 officially repealed it and permitted commercial banks to engage in investment banking, insurance and other financial services.

But now, in the wake of the current financial meltdown, the governor of the Bank of England, Mervyn King, is openly speculating whether a Glass-Steagall separation would not be good for the UK banking system.

“There are good arguments in favor, to separate the utility functions of a retail bank taking household deposits and running the payments system from the casino trading of an investment bank,” King said in a speech in March, “and good arguments against - the difficulty of maintaining a credible boundary between those institutions that are eligible to receive government support and those that are not.” King concluded: “We need a public and informed debate on the merits of the arguments.”

The Times of London reported this week that the Bank of England is actually investigating whether it would indeed be a good idea to separate commercial and investment banking. Also this week, George Osborne, the “shadow” Chancellor of the Exchequer – the opposition party member who would become the equivalent of Treasury secretary if the opposition came into power – said the Conservatives would break up the big national banks and limit the size of banks if, as expected, they win parliamentary elections that must take place by June 2010.

The UK, while it never had its own Glass-Steagall Act, did have more restrictions on combining the activities prior to its “Big Bang” in 1986, which generally deregulated the financial services industry.

The debate in the UK could have repercussions here. It could encourage U.S. lawmakers who want a restoration of Glass-Steagall to press ahead with legislation even without a formal blessing from the administration. The commitment by world leaders at the recent Group of 20 summit in London to coordinate regulatory reform and supervision would create a certain momentum in that direction if the UK took the lead. It is unlikely, given the globalization of financial markets, that the UK would take the step alone and put its banks at a competitive disadvantage vis-à-vis other countries.

There are many who argue that combining a “utility” like commercial banking and a “casino” like investment banking was not the cause of the meltdown. Responding to King’s suggestion about separating the two, British commentator Hugo Dixon said, “True, these ‘universal’ banks lost money in the casino. But they also lost pots of cash through straightforward bad lending.”

It was not abuses or conflicts of interest from combining the two activities that led to problems, Dixon said, but bad risk management across the board. So the solution is not quarantining certain activities, but getting better risk management.

However, there are many in the U.S. who would like to return to the days when highly regulated banks made reasonably safe loans to clients they knew. Paul Krugman, the Nobel Prize-winning economist who has been a fierce critic of the administration’s plans to bail out the banks, this week called for banking to be “boring” once again.

“But my sense is that policy makers are still thinking mainly about rearranging the boxes on the bank supervisory organization chart,” Krugman wrote in his New York Times column. “They’re not at all ready to do what needs to be done — which is to make banking boring again.”

Krugman does not explicitly call for reinstatement of Glass-Steagall, but it would be hard to make banking boring without those kinds of restrictions.

But those “policy makers” that Krugman is so dubious about all have their share of the credit or blame for doing away with Glass-Steagall and have come under recent criticism for their roles in deregulation. They include White House economic adviser Lawrence Summers, House Financial Services chairman Barney Frank, and Senate Banking chairman Christopher Dodd.

Paul Volcker, the former Fed chairman who advised President Barack Obama during his campaign and now heads something called the Economic Recovery Advisory Board, has been lobbying for a new separation of commercial and investment banking, first in a Group of 30 report published in January and again in January in a talk in New York. For his troubles, he has been effectively sidelined and for now, at least, has little role in administration policymaking. His board has yet to meet.

So as long as Summers and his protégé, Treasury Secretary Timothy Geithner, have the upper hand in administration circles, it doesn’t look like there will be any White House proposals for a new Glass-Steagall, or even a public debate about it.

Darrell Delamaide is a veteran financial journalist who has worked for Dow Jones, Bloomberg, Institutional Investor, among others. He is based in Washington, D.C.