The Economic Cost of Repealing Glass-Steagall

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When one bets on a sporting event, the facilitator of the bet, a “bookie,” charges the winner of the bet the “vigorish.” The vigorish, commonly known as the “vig,” is a fixed percentage of the bet that serves as compensation to the bookie for providing betting options (liquidity) and the financial surety of collecting on winning bets.

Financial institutions, like bookies, are intermediaries. They link borrowers with lenders and investors and provide financial security similar to bookies. The fees, or vig, they charge can be thought of as a tax on capital transactions and thus a tax on the economy. If the vig is excessive, individuals, businesses, and the government are unnecessarily sacrificing capital and wealth to bolster the profits of financial institutions.

Regulation is a form of interventionism representing a direct or indirect tax on the economy. More often than not, regulations slow the economic engine with few redeemable benefits and a multitude of unintended consequences. However, sometimes regulation is well worth its cost as it provides benefits that outweigh the economic tax and the burden put on others.

The Glass-Steagall Act of 1933 was one such example. While the act narrowed the lines of business in which banks could participate, it protected the banks and, more importantly, the nation’s populace from economic depression. Many factors have weighed heavily on the economy in recent years, and the repeal of Glass-Steagall is one of them. Its repeal in 1999 provides a clear breakpoint in the history of financial institutions and the activities this regulation once restricted.

Removing the handcuffs

Financial institutions serve as a crucial cog in the economic engine by allowing capital to flow more efficiently. Consider how hard it would be to get a mortgage or auto loan if you had to go to family and friends to borrow money. The task is infinitely complicated when one considers the companies and governments that seek to borrow hundreds of millions, billions and even trillions of dollars.

Financial institutions that facilitate capital transactions are paid fees. When a financial institution acts as a broker in the trading of secondary market securities, they are typically rewarded with a bid/offer spread or a commission. In the case of new equity and debt offerings, they are paid a fee by the issuing entity. Interest rates on traditional loans to individuals and businesses are typically offered at a spread to the institution's cost of borrowing, thus ensuring compensation for the financial institution providing the loan. Financial institutions require these fees to incent them to commit their capital and, equally importantly, to protect them from the financial risks embedded within these transactions.