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June 22, 2009
Repeal of Glass-Steagall to Blame for Crisis?
Remember the last time our economy was in this much trouble? That was during the Great Depression. And whether you love or hate to compare that meltdown with today's, you have to admit one thing: our banking system was at the center of the chaos both times.
After the original collapse, President Franklin D. Roosevelt reacted by signing the Banking Act of 1933, colloquially known as the Glass-Steagall Act. The Glass-Steagall Act prohibited any firm to offer both commercial and investment banking services. Economists and politicians in the post-Depression era blamed such firms for the stock market crash of 1929. According to them, commercial banks should be separated from investment banks because the former grant clients credit, whereas the latter use credit to sell equity on behalf of the client. Proponents of the act saw this as a conflict of interest between the sectors.
To understand this conflict of interest, imagine working for a conglomerate bank. You have just issued a bad loan to a corporation and want to hedge against a default. Thus, you underwrite an initial public offering on behalf of the corporation and begin issuing its shares to investors. The incoming cash flows pay off the loan, transferring the risk to unaware investors.
Of course, investors would catch onto banks that frequently sell risky stock. The bank would lose sales due to the negative public opinion. Critics of Glass-Steagall used this argument to suggest that banks must practice responsible lending and investing practices, whether combined or separate. According to them, this made the act unnecessary.
Glass-Steagall opponents also cited that strictly regulated banks were losing sales to foreign financial institutions not restricted by the act. Domestic banks could not compete as investors began taking their money abroad.
The regulations also undermined the benefits of consolidating commercial and investment banking services. Pure investment banks needed to find external investors to raise capital for their clients. Conglomerate banks could simply underwrite their own funds from the millions or even billions of dollars in their deposit accounts. The synergy gained from operating in both fields would enable them to serve clients much more quickly - and earn much more profit.
In 1999, President Bill Clinton repealed the Glass-Steagall Act for the reasons mentioned above. He was also under pressure from commercial banks, who had already started acquiring investment banks. After the deregulation, mergers between both types of banks became the norm on Wall Street. Most leading banks are now conglomerates, including JPMorgan Chase & Co., which enjoyed tremendous growth immediately after the repeal.
The benefits of the repeal were short-lived. Today's financial crisis struck less than a decade after the removal of Glass-Steagall. Coincidence? Or failure to learn from history? Although Glass-Steagall was not perfect, it was effective. Under the act, the financial sector remained intact and weathered several recessions. The exception came almost immediately after a deregulation act in 1980. That act loosened Glass-Steagall's restrictions and preceded the only financial crisis during Glass-Steagall's tenure. The point? Tampering with Glass-Steagall is just asking for trouble.
But why? What is so special about the 76-year-old act anyway?
Well, for starters, dealing with securities is risky business. Should an investment bank with a commercial arm lose money in capital or derivatives markets, it might not have sufficient funds to cover clients' deposits, causing a liquidity crisis. Depositors might not be able to withdraw their own money. Since the government insures deposits, it would be forced to refund the furious depositors.
Banks that offer both services have greater market share, threatening competition for investments and loans. Also, should a very large bank fail, clients could incur massive losses themselves. Glass-Steagall prevented banks from taking over the market and encouraged healthy competition.
While Glass-Steagall critics argue that conglomerate banks grow much faster, they should consider the long-term implications. Right now, bulge bracket and boutique banks alike are collapsing left and right. While they were better off right after Glass-Steagall, they are suffering in the long run. Steady long-term profits are better than a quick payday followed by bankruptcy filing. Separating services is in the banks' best interests.
Risky investments backfired on investment banks, and their commercial arms are taking some of the punishment. These are the commercial arms in which you safeguard your hard-earned money. Do you really want them to lose this money by dealing in unpredictable securities markets?
Posted by iaijazud at June 22, 2009 08:59 PM