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With The Credit Crunch A Year Old, Is It Time To Revisit The Glass-steagall Act?

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As we approach the first anniversary of the credit crunch, is it the end of the world as we know it for investment banking, the industry now universally blamed for the present mess?

Most investment bankers would still scoff at the idea. Yet even the most ebullient are being forced reluctantly to admit that the consequences of the present implosion are likely to be rather more momentous than previous cyclical downturns in which bankers have similarly been painted as villains. After past crises, they have nearly always come bouncing back after a few years of lying low. This time, it looks much more serious.

Nor is it just the threat of regulatory backlash which stands to clip their wings. Bear Stearns is already history, and at least three of Wall Street's bulge-bracket firms – Lehman Brothers, Merrill Lynch and UBS – will struggle to survive in their present form.

All three have been so neutered by the events of the past year that they can now scarcely be regarded as "bulge bracket" at all. In any case, it seems unlikely they will remain as the integrated investment banking operations they were. Lehmans may yet disappear entirely, UBS might shrink back to its core private banking franchise and Merrill Lynch too will surely return to its roots in traditional retail broking and asset management. Big challenges, both market-based and regulatory, lie ahead for those that try to maintain the game.

According to talk on Wall Street, so desperate have the investment bankers become for reasonably priced funding that even the mighty Goldman Sachs is now in the market for a sizeable retail bank that might give it access to cheap money. As things stand, some investment banks are paying up to 250 basis points over bank rate for funds, an unsustainably high rate, which undermines much of what they do.

At the same time, investment banks are facing the parallel threat of regulatory backlash. The quid pro quo for being allowed to borrow from the Federal Reserve's discount window is that investment bankers will have to accept a much higher degree of oversight. Again, this is going to affect much of what they do. Yet even if investment banks attempt to become "universal banks" – like JP Morgan Chase, Citigroup, HSBC or Barclays – it may not provide any relief.

Those political voices on both sides of the Atlantic clamouring for a return to something like the Glass-Steagall Act of the 1930s, which among other things forced a rigid separation of investment and commercial banking, grow ever louder. It may be a bit far fetched to cite repeal of Glass-Steagall by the Clinton administration in the late 1990s as the main cause of the present crisis, but this act of deregulation certainly can't have helped. When banking lender and fee earner become one and the same, it sets in train a fundamental conflict of interest, which is almost bound to end badly.

After Glass-Steagall went, investment bankers did more conventional lending and commercial bankers did more fee earning. The "originate and distribute" model for banking took off like wild fire. Commercial banks became more like intermediaries than traditional lending institutions. They would take a fee on originating the loan, then another on securitising, syndicating or otherwise distributing it. The process was meant to leave the bank free of the risk of default. Certainly it encouraged the collapse in lending standards that lies at the heart of the crisis.

If "originate and distribute" was meant to lay off the risk with others, how come so much of it ended back on the originators' books? The answer lies only in part in the practice of "warehousing", where banks would take the loans or securities on to their own books ahead of selling them out into the market. When the music stopped, they were left with the unsold risk.

In some cases, senior, apparently lower risk, tranches of the debt would be held back to expand the bank's own balance sheet. Yet much worse was the absence of centralised risk controls. While one part of the bank was selling out the risk of sub-prime mortgages, leveraged loans and so on, the proprietary trading desk on another floor or a different country was all too likely to be buying it back again in the hope of making a fast buck.

Treasury functions became seen as profit centres, rather than risk-control departments. Bizarrely, HBOS and others bought US mortgage-backed securities as part of their liquidity pools, a bank's key source of cash for depositor withdrawals, believing these triple-A rated bonds to be as safe as gilts, but higher yielding. The latter characteristic should have told them all they needed to know, but the warnings were ignored.

It is small wonder that now all these practices, and others more complex and ingenious still, have become exposed to the cold light of day, that everyone has lost faith in the banking system. To regain that trust, investment, retail and commercial banks need entirely to reboot.

I assume this is 250 points above the feds 2%, so that's 4.5% the investment banks are paying in interest and they can't make ends meet. The FED should cut to 0% to save the boys on wall street or even or for -0.5%, give the investment bankers some profit and bonus opportunities.

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