A decade after Glass-Steagall's repeal, it's time to reverse Sandy Weill's legacy

The Glass-Steagall Act -- a law passed in 1933 that separated investment banking from commercial banking with the aim of preventing another Great Depression -- was repealed exactly 10 years ago today at the urging of Sandy Weill so that Citicorp and Travelers (TRV) could merge and from Citigroup (C).

Weill, at the time the CEO of Citicorp, got then-Treasury Secretary Robert Rubin's support for what turned out to be a disastrous regulatory change, one that was finally passed as Rubin passed the baton to his successor -- Larry Summers (now director of President Obama's National Economic Council). That's because the repeal freed Citi to combine commercial, consumer and investment banking into a one-stop shop -- and created a recipe for financial disaster.

How so? First, the merger was bad for Citi shareholders -- largely because Weill's one-stop-shop concept failed with consumers and with the merged pieces. Now, Citi's recent near-death experience has left taxpayers on the hook for $306 billion. And were it not for the passage of the Gramm-Leach-Bliley Act, which repealed Glass-Steagall in 1999, it's quite possible that our current financial crisis would not have happened.

How so? Citi's growth to the point where it was too big to fail (or even manage) was a direct result of repealing Glass-Steagall. Although Citi wasn't the only bank that the federal government decided to prop up during the current crisis, it certainly was the biggest and most costly for taxpayers. Yet were it not for the combined wills of Weill and Rubin, we might not be in the mess we're in now.

What the federal government ought to do now is restructure the architecture of finance. Banking should be returned to a supporting function in which it can no longer take actions that put the entire global economy at risk. What would it take to do that? As I have previously posted, six reforms should be put in place.

If those reforms pass into law, I have promised that I would dance a hula on Wall Street. But since I believe that Wall Street has effectively purchased the Treasury Secretary's office, I don't expect to find myself gyrating in a grass skirt anytime soon.

But likely or not, here are the six ways I think we need to re-architect finance:

End securitization. If financial engineers can find a way to bundle loans into securities that are guaranteed not to lose money for investors, then securitization should continue. The collapse of the market for mortgage-backed securities and collateralized debt obligations demonstrates that achieving this could be nearly impossible.

If there's a way to reconstitute the benefits of securitization -- namely, lower interest rates for borrowers -- without the costs we're now incurring, then it might make sense to continue the practice. Otherwise, end it for good.

Lower leverage. We should closely monitor all actors in the financial system -- including banks, hedge funds, insurance companies, businesses and households -- to set clear targets for maximum leverage and to ensure that none of them is able to exceed those targets. More important, we need to create a culture of savings and living within one's means to extinguish the urge to borrow and spend more than one can repay.

Enforce transparency. Trust in the financial system depends on timely, accurate and complete information. Such information should extend across all kinds of financial transactions -- providing investors with the ability to assess the financial strength and future prospects of the companies in which they invest; giving companies knowledge of the soundness of their partners, suppliers and customers; and providing consumers a true picture of the honesty -- or lack thereof -- of their lenders and brokers.

In the year since I made that suggestion, the Madoff scandal has revealed that we're still suffering the effects of letting managers write their own report cards. No progress has been made on freeing us from that systemic flaw.

Create morally defensible incentives. As I've posted, bankers and other participants in the financial system get paid to bring in big volumes of business. Their bonuses are calculated as a percentage of the size of their deals. If investors later lose their investments in those deals, the bankers get to keep their money. To fix this problem, I would require them to keep their bonuses in an escrow account.

If after, say, five years, that investment were still valuable, the banker would receive the money out of escrow. Otherwise, the escrow would pay the losses that the investor incurred from the bad deal. This kind of structure could reduce the moral hazard in the current incentive system by encouraging bankers to book deals likely to make money for investors.

Build global firewalls for derivatives. Designers of our new financial system needed to establish ways to keep the problems of one institution from bringing down others -- whether in the U.S. or in other parts of the world. For instance, AIG's collapse could have damaged many of its interconnected credit default swaps counterparties. However, that problem would not have arisen if there had been an independent exchange for trading CDS.

Break up companies deemed too big to fail. I believe that there's a limit to how big financial institutions should get. When they exceed that size, the government should require them to break up into smaller pieces. The reason is that we shouldn't be rewarding managers for building big companies that can't earn profits that exceed their cost of capital. And we should not require taxpayers to pay for the cost of such failure.

At this point, the financial system has become far too complicated to go back to the days where simply separating investment and commercial banking could prevent financial Armageddon. But we certainly need to return to the spirit in which Glass-Steagall was passed back in 1933 -- the desire to keep Wall Street from ruining the world.

These six principles would help us get there.

Peter Cohan is a management consultant, Babson professor and author of nine books, includingCapital Rising (due in June 2010). Follow him on Twitter. He owns Citi and Travelers shares.

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