A revised Glass-Steagall Act is essential for functioning, safe banking

Economists, investors, and business executives alike certainly hope there's progress on a variety of fronts -- fiscal stimulus, trade, banking regulation -- at the G-20 summit. Regardless of that progress, though, the United States should move forward with one critical reform: re-regulating the banking sector.

In the vernacular of the day, the U.S. has to pass more-effective regulations, but the nation can start with a tried-and-true formula -- re-enact the Glass-Steagall Act.

A New Deal-era safeguard

Repealed in 1999, Glass-Steagall was initially passed following the 1929 stock market crash after a deluge of commercial bank failures across the nation. The act separated commercial and investment banking, and for good reasons: at the time, commercial banks were taking on too much risk, and their insolvency threatened the financial system.

However, during a wave of deregulation, economic conservatives and free market absolutists argued for, and won, a repeal of Glass-Steagall in 1999, contending that the act hindered the market from deploying new products and companies from implementing efficiencies that would benefit clients. In retrospect, the repeal has to rank as one of the most misguided, problematic pieces of banking/financial services legislation in the modern/postmodern eras.

As I posted earlier, it makes a great deal of sense to have two bank tiers. One with banks that take few investment risks, such as savings and mortgage loan-oriented ones, that are backed by FDIC insurance, and another tier of banks that are investment-oriented and take greater risks in exchange for greater returns, that are not backed by federal insurance. It's a two-tier banking system that's essential to ensure a functioning, safe banking for the public, and the availability of diverse investment products for corporate and institutional investors.

Hence, the Obama Administration and the U.S. Congress should pass a modified Glass-Steagall Act this year. Former U.S. Federal Reserve Chairman Paul Volcker has also expressed his support for some type of two-tier banking system.

Hedge funds and banks don't mix

Further, another change that federal regulators must implement is the separation of hedge funds from banks. Whoever thought that providers of capital that's critical to the financial system and the economy should somehow be allowed to run the entities that represent the epitome of risk, leverage, speculation, capital deployment creativity and experimentation, must have had a monumental brain freeze; hedge funds commingled with banks was an accident waiting to happen. What history has demonstrated is that some entities were clearly not meant to take risks.

Let's hope that as Americans we don't find out too painfully that selected banks are decidedly in that latter camp.

Financial Editor Joseph Lazzaro is writing a book on the U.S. presidency and the U.S. economy.

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