Thomas Hoenig, the vice chairman of the FDIC, recently called for the removal of federal insurance as a “safety net” for non-bank activities and a return to the framework of the Glass-Steagall Act.
“For decades the principle of limited subsidy was understood and practiced,” Hoenig said. “The Glass-Steagall Act kept commercial banks and the government safety net separate from investment banking and broker-dealer activities. Just as importantly, investment banks were kept separate from the payments system and from funding their activities with insured deposits.”
Glass-Steagall was enacted in the wake of the Great Depression but was replaced by the Gramm-Leach-Blily Act in 1999.
Hoenig said that the break-up of America’s largest banks and the placement of non-bank activities in separate companies to compete for investment could potentially eliminate “too big to fail.”
“Structured correctly and without a government backstop, the market would demand stronger capital and safer asset growth,” Hoenig said. “This in turn would enhance the ability to place them into bankruptcy instead of the arms of the taxpayer, should they run into trouble.”
Hoenig also said that while the safety net is critical to meeting liquidity demands, it creates a “moral hazard” because creditors worry more about firm’s financial state instead of getting their money back, which is intensified as financial institutions become larger.
“Subsidizing noncore banking activities such as underwriting, proprietary trading, market making and derivatives encourages firms to bring these business lines onto their balance sheets using more debt, most of which is very short term,” Hoenig said. “The effect is to make the financial system increasingly fragile, and it becomes proportionately more difficult to allow these firms to fail. Thus, to realistically address the problem of too-big-to-fail, these activities must again be separated.”