Are Citigroup's troubles evidence that Glass-Steagall repeal was a colossal mistake?

Having made the argument a couple of months back that repealing the Glass-Steagall Act was a good thing because it allowed J.P. Morgan Chase to buy Bear Stearns and Bank of America to (maybe) buy Merrill Lynch, I've been feeling a little guilty about not having revisited it yet in light of Citigroup's troubles. So here goes:

It was the merger of Citicorp and Travelers Group in 1998 that forced Congress's hand on Glass-Steagall repeal in 1999. Citi was a venerable banking company. Travelers was a concoction thrown together in little more than a decade by Sandy Weill, with big businesses in insurance, investment banking (Salomon Brothers), retail brokerage (Smith Barney), and consumer lending (Commercial Credit). The Glass-Steagall Act, enacted in 1934, aimed to keep banks separate from those other financial sectors. Now they were together in one company.

Since then, the biggest problems at Citigroup have come from the Travelers' side of the marriage. The Travelers insurance businesses have been spun and sold off, and Smith Barney, as part of Citi's wealth management division, doesn't seem to have been a disaster. But Citifinancial was a leading subprime mortgage lender, and Citi's investment banking arm--the descendant of Salomon Brothers--got into mortgage securitization late and ended up with a huge pile of unsellable junk on its hands.

Now that junk has rendered all of Citi suspect, and the feds have felt obliged to jump in with a big bailout. I'm not sure that in itself is evidence of Glass-Steagall repeal's disastrousness: Travelers Group was already so big and so interconnected that it might have merited a similar deal all on its own. But it does seem that managing Citigroup's diverse businesses posed a challenge that Weill's successors weren't up to. Maybe Jamie Dimon--the longtime deputy Weill drove away from Citigroup soon after the merger--could have managed them all successfully. But the mere mortals who took his place could not.

This brings me back to something Wells Fargo chairman Dick Kovacevich--a Citi alumnus--told me in an interview last fall:

The reason we are not in investment banking business in a large way is that it's culturally incompatible with the traditional banking business. We are a relationship-oriented bank. We have a team of people serving our customers. We reward our people to some degree on their individual performance but there's a lot of team incentives, including the incentive of how the entire corporation performs.

Investment banks, on the other hand, tend to be very transaction-oriented. They're doing deals. Then they go to the next deal, and the next deal. They tend to be a company of stars. They reward individual performance much more than team performance.

When you have a large diversified company the only thing that holds it together is a shared culture and common vision. You can't have multiple cultures working in a large company or it is going to be dysfunctional. Or at least that was our hypothesis.

A lot of what Wells Fargo does as far as selling insurance and investment products to its customers would run up against the old Glass-Steagall limits (although many of those limits had already been rolled back by banking regulators before Congress made things official). The real problem was in trying to merge  transaction-oriented investment banking with relationship-oriented banking.

The mismanagement apparently inherent in combining banks with big investment banks might be a legitimate argument against Glass-Steagall repeal. It does happen to be almost the diametric opposite, though, of another popular argument for why Glass-Steagall repeal was a disaster--because it led to a situation in which, to quote John Cassidy, "remaining Wall Street firms, grappling with new competition in their traditional businesses, increased their borrowing and made riskier bets."

More important, the Glass-Steagall arguments miss what seems to me to be the real issue: that transaction-oriented investment banking has, now that we've been able to adjust previous years' returns for risk, turned out to be a bust. M&A work will eventually come back, and so will some amount of securities underwriting. But the vast securities-manufacturing business that evolved over the past three decades and went into overdrive after 2000 may never recover. This is what's meant by the shadow banking system, and it began slithering its way out of the reach of banking regulators in the 1970s, more than two decades before the Gramm-Leach-Bliley Act put an end to the Glass-Steagall separation of banks and Wall Street. Some advocates of Glass-Steagall repeal (Jim Leach in particular) actually saw their legislation as a way to rein in some of the shadow banking nonsense and bring it back under the control of banks and the watchful eye of bank regulators.

That didn't work out so well--in part because the chief banking regulator at the time, then Fed chairman Alan Greenspan--didn't believe in regulating. But obsessing over Glass-Steagall distracts us from the main flaw in our regulatory structure, which is that it allowed the rise of big leveraged financial institutions that weren't subject to the same rules as banks but now turn out to have been running the same (or even bigger) risks.

Kevin Drum, who has been doing a spectacular job of teaching himself about high finance over the past couple of months, sums it up nicely:

For my money, I keep coming back to the same thing: leverage, leverage, leverage. The key is to regulate leverage to reasonable levels and to regulate it everywhere. If it walks like a bank and quacks like a bank, then it's a bank and its leverage ratios should be regulated.