Don't Break the Banks

Why Obama's plan to reinstate Glass-Steagall is a terrible idea

When Joseph Olear opened his renovated Three Point Bowling Center in south Orlando last May he didn't anticipate Wachovia taking an ax to his line of credit. Yet three months later the bank cut Olear's access to credit by almost 15 percent. "I opened up my statement and whack!" he says. "I thought, I should still have [more credit] to draw on. Nope." Did Wachovia slash Olear's credit because his business was failing? On the contrary, since opening his renovated facility, profits are up 25 percent. "In a down economy, an inexpensive sport like bowling becomes popular," Olear says. "Instead of groups doing Sea World or a golf outing, we're seeing them come here."

The reason Olear can't secure enough credit for his small business stems from issues far beyond the warmth and sun of central Florida. Credit is sparse nationwide, as banks hold their cash tight in a very uncertain economy.

That uncertainty stems largely from Washington's hostility to Wall Street. In the past few weeks, President Barack Obama has ratcheted up his rhetoric against the big banks, demanding they start lending more money to small businesses and fulfill their moral duty to help out average Americans, particularly in the wake of Wall Street's own financial bailout.

And the president has gone well beyond mere rhetoric, proposing a harsh new liabilities tax targeted at the top 50 or so financial firms (or any firm with assets over $50 billion) as well as new limits on how banks may be formed. That second proposal would effectively reinstate the wall of separation between commercial and investment banking that was first erected with the Glass-Steagall Act of 1933 and later repealed by the Financial Services Modernization Act of 1999. Together with threats of increased capital requirements from the White House and federal lawmakers designed to reform financial services, these proposals have banks of all sizes holding tight to their wallets.

In a normal economy, successful small businesses like Olear's (he says January is going to be a record month for profits) wouldn't face such a cold credit market. And Obama has certainly gone out of his way to show empathy for struggling small business owners. So it is ironic indeed that Obama now wants to handcuff or dismember the very banks that will offer this badly needed credit.

Here's the trouble with Obama's plan. First, separating commercial and investment banking is not the path to increased lending. Last week Rep. Judy Biggert (R-Ill.) explained to the Security Traders Association of Chicago why a return to the spirit of Glass-Steagall would cripple banks. "If firms are unable to buy and sell assets, where will liquidity come from in the future? How will auto loans and home mortgages be financed?" And the more banks that are handicapped, the less credit there will be flowing into the marketplace.

Nor did Wall Street respond well to the news that the big banks—a vital foundation upon which so much economic growth has been generated—might be broken up or have their business practices restricted. In the wake of Obama's attack, the Dow Jones lost 5 percent, erasing all gains since November 6, 2009. Similarly, the Nasdaq lost 5 percent and the S&P 500 lost 6 percent.

Was there lending in America before the repeal of Glass-Steagall? Sure. Much of America was built on the classic Savings & Loan model where deposits were lent out on a micro basis. But community banks simply don't have the capacity to meet the current demand for credit from corporations, small businesses, plants, and families. Breaking up the big banks would slam the brakes on the American economy.

Second, Obama's tax proposal will be a disaster for businesses and consumers. The U.S. Chamber of Commerce believes that expanding the tax burden will fundamentally undermine America's commitment to free enterprise. As J.P. Morgan Chase CEO Jamie Dimon has pointed out, "Using tax policy to punish people is a bad idea…. All businesses tend to pass their costs on to customers." This would be a double hit to the small businesses who've seen their credit decline thanks to the regulatory threats leveled at the big banks.

Even the diabolical political theorist Nicolo Machiavelli realized the risks inherent in using the "fear of taxes" as a punishment. Instead, Machiavelli advised good administrators to "provide rewards for those who desire to employ themselves."

Besides, even if the costs of the tax were not passed along to consumers, the tax would still fail to promote more lending. The problem with the credit shortage isn't that small banks can't compete in lending with the big ones. The problem is that the large financial institutions aren't readily shelling out cash like they did during the bubble years. This is partly because of a healthy reduction in excessively risky lending, but that reduction is also being exacerbated by the administration's perverse rhetoric.

Meanwhile, Obama inexplicably continues to pressure banks to lend more, while at the same berating them for lending too liberally.

Joseph Olear and other small business owners would love for banks to be able to relax their lending restrictions. But this won't happen until Washington ends its vindictive war on Wall Street.

Anthony Randazzo is director of economic research at Reason Foundation and author of the study "Rebuilding Wall Street: A Review of the White House Proposal for Reforming Financial Services Regulation."