Would Splitting Up Commercial and Investment Banks Harm the Economy?

Earlier in July, Elizabeth Warren, the newly elected advocate Senator from Massachusetts, proposed splitting up banks’ commercial and investment banking businesses into two completely separate business units.  Her catchphrase for her desire is: “Banking should be boring.” Joined by senators McCain, King, and Cantwell, the bill states as its purpose: to reduce risks to the financial system by limiting banks’ ability to engage in certain risky activities and limiting conflicts of interest, to reinstate certain Glass-Steagall Act protections that were repealed by the Gramm-Leach-Biley Act and for other purposes …

Overall, the ideas behind the bill are simply rehashed complaints that are approaching a century in antiquity.  The complaints, as stated in the bill, include issues with deregulation and risk taking, the complexity of big banks’ balance sheets, concerns about derivatives and trading activities, and general disgust over lack of government oversight. The bill cites such reports as the Vickers Independent Commission on Banking (United Kingdom), the Financial Stability Oversight Council (United States), and the Liikanen Report (Euro area) as entities finding weaknesses associated with the current activities of investment banks.

The question here is: how much would splitting up the commercial and investment banking businesses of investment banks harm the economy?

In order to answer this question, one has to appreciate the relationship between risk and economic growth and the extra risk enabled by merging commercial and investment banking businesses.

As a general background, typically risk-taking is associated with increased economic growth. In fact, in all economic boom cycles, risk-taking was present, and generally an important contributor to healthy economic conditions. And why is risk-taking important for economic growth?  The simple answer is that risk-taking leads to innovation, new products, investment, and other economic activities essential to economic expansion.

In fact, as a matter of common understanding, a highly important factor contributing to the advantage the United States has in technological innovation (Silicon Valley) is partly due to the venture capital system, where investors make very risky bets on innovative start-up companies.  The ecosystem and connection between technological innovation and financial risk-taking is only the tip of the iceberg regarding the high importance of financial risk-taking.

Advocates for greater government regulation will simply reply that venture capital risk-taking is completely different than the risk-taking in which investment banks are engaged, which is true to a degree. Essentially, regulation advocates for the investment banking industry point to the broad effect big investment bank activities can have on the economy if they fail, compared to the relatively small effect on the economy when venture capital firms fail.  The example most commonly given is the recent recession and the associated bailouts of certain financial firms.

How could a person with an understanding of the importance of the free-market respond to the regulation proponents?  The easy answer is that the problem lies with government policy rather than the investment banking industry’s world class risk management experts. Essentially, having a government backstop encourages more risk-taking than what might happen if bankruptcy was always on the table.

With this brief background in mind, how might splitting up the commercial and investment banking businesses of big banks affect the economy? Empirical evidence does not provide an easy answer. For example, here’s what economic growth looked like before the Glass-Steagall Act of 1933, after the Glass-Steagall Act was implemented, and after the Gramm-Leach-Biley Act took effect in 1999.  The data behind the chart doesn’t give any more conclusions than the ambiguity introduced by the chart.

GS

In doing some further analysis by using input-output matrices, one could reasonably assume that splitting up investment banks may decrease employment in the economy by up to 10,000 people.  Not a lot, but then again, in a very competitive globalized economy, every job matters.

Overall, Senator Warren’s idea of breaking up the investment banking and commercial banking components of big investment banks would likely have some downside effects on the economy, including a potential of a significant drop in employment economy-wide.

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