Page 3 of 4 CREDIT BUST
BYPASSES BANKS PART 2: Bank deregulation
fuels abuse By Henry C K Liu
established the Federal
Deposit Insurance Corp (FDIC), insuring bank
deposits, and strengthened the Federal Reserve's
control over credit.
The 1933
Glass-Steagall Act became a key pillar of banking
law by erecting a regulatory wall between
commercial banking and investment banking. The law
kept banks from participating in the
equity markets, and equity
market participants from being banks. The relevant
measure of the Glass-Steagall Act is actually the
Banking Act of 1933, containing the provision
erecting a wall separating the banking and
securities businesses. It also left a small
loophole to allow the Federal Reserve to let banks
get involved in the securities business in a
limited way to relieve otherwise cumbersome
operation.
Glass-Steagall (actually two
acts arising from bills sponsored by Democratic
senator Carter Glass and Democratic congressman
Henry B Steagall) was born during the Great
Depression. The US banking system was in shambles,
with more than 11,000 banks having failed or had
to merge, reducing the number of surviving banks
by 40%, from 25,000 to 14,000. The governors of
several states closed their state banks and in
March 1933, president Franklin Roosevelt briefly
closed all the banks in the United States.
Congressional hearings conducted in early 1933
concluded that the trusted professionals of the
financial markets - the bankers and brokers - were
guilty of disreputable and dishonest dealings and
gross misuse of the public trust.
Historians, while acknowledging the role
of malfeasance, now understand that the chief
culprit of bank failures was structural, with
inadequate regulations that permitted market abuse
to become regular practice. Unethical practices
were legal, and competition was conducted under
the law of the financial jungle.
The
Banking Act of 1933 was the newly elected
Roosevelt administration's response to the
perceived shambles of the nation's financial and
economic system. But the act did not address the
structural weakness of the US banking system: unit
banking within states and the prohibition of
nationwide banking. This structure is a key reason
for the failure of many US banks, some 90% of
which were unit banks with less than $2 million in
assets. The act instituted deposit insurance and
the legal separation of most aspects of commercial
and investment banking, the principal exception
being allowing commercial banks to underwrite most
government-issued bonds.
Carter Glass was
then a 75-year-old senator who physically stood
only 163 centimeters tall but was historically a
towering figure. A former Treasury secretary, he
was a founder of the Federal Reserve System and a
vocal critic of banks that engaged in the risky
business of investing in stocks. He wanted banks
to stick to conservative commercial lending, and
he exploited traditional anti-bank sentiments to
push through changes. Henry Steagall, a rural
populist from Ozark, Alabama, the Democratic
chairman of the House Banking and Currency
Committee, signed on to the bill to attach an
amendment that authorized bank deposit insurance.
Senator Glass was convinced that banks
should not be involved with securities
underwriting or investment, as such activities
violated basic rules of good banking. As
intermediary custodians of money, banks'
involvement in equity markets would lead to
destructive speculation, as evidenced by the crash
of 1929 with its bank failures and the subsequent
Great Depression.
Curbing the natural
monopolistic tendency of banks has been a common
legislative theme throughout US history until the
recent onslaught of economic neo-liberalism.
During the 1930s and 1940s, US banks were
regulated to stay within the basics of taking
deposits and making secured loans funded by
deposits.
Congress did not intervene until
1956, when it enacted the Bank Holding Company Act
to keep financial-services conglomerates from
amassing excessive financial power. That law
created a barrier between banking and insurance in
response to aggressive acquisitions and expansion
by TransAmerica Corp, an insurance company that
owned Bank of America and an array of other
financial services businesses. Congress thought it
improper for banks to risk possible losses from
underwriting insurance. While many banks today can
sell insurance products provided by insurers,
banks are not permitted to take on the risk of
underwriting.
TransAmerica began when a
young entrepreneur named A P Giannini started a
small bank known as the Bank of Italy, later to be
known as Bank of America. Giannini acquired
Occidental Life Insurance Co through TransAmerica
Corp in 1930. The 1956 Bank Holding Company Act
prohibited a company from owning both banking and
non-banking entities. The company decided to
divest itself of its bank holdings and keep its
core life-insurance businesses and related
services under the TransAmerica name. As a
financial conglomerate, it acquired motion-picture
studio and distributor United Artists, Trans
International Airlines, and Budget Rent-A-Car.
The rise and fall of
conglomerates As private equity is the rage
today, conglomerates were the new trend in the
1960s, exploiting a combination of low interest
rates and recurring alternative cycles of
bear/bull markets, which allowed the conglomerates
to acquire companies in leveraged buyouts at
temporarily deflated values with loans at negative
real interest rates.
As long as the
acquired companies had profits greater than the
interest on the loans used to buy them, the
overall leveraged return on investment (ROI) of
the conglomerate grew spectacularly, causing the
conglomerate's stock price to rise sharply within
short periods. High stock prices allowed the
conglomerate to borrow more money without altering
its debt-to-equity ratio, with which to acquire
even more companies. This led to a chain reaction
that allowed conglomerates to grow very rapidly.
But when interest rates finally rose to
catch up with inflation, conglomerate ROI fell
when anticipated "synergies" from owning
diversified businesses failed to live up to
expectation and conglomerate shares fell in market
value, forcing them sell off recently acquired
companies to pay off loans to maintain the
required debt-to-equity ratio.
By the
mid-1970s, most conglomerates had been dismantled,
as many private-equity deals are expected to be in
coming months.
Attempts to repeal
Glass-Steagall Repeated unsuccessful
attempts were made after 1933 by commercial
bankers and sympathetic regulators to repeal or
draft exceptions to those sections of
Glass-Steagall Act that mandate separation of
commercial and investment banking. As a result,
the United States and Japan - which was forced to
adopt laws similar to the US banking statues after
World War II - alone among the world's major
financial nations, legally require this
separation. Japanese banks can engage in many
securities activities, however, including
underwriting and dealing in commercial paper and
ownership of up to 5% of non-bank enterprises.
Beginning in the 1960s, US banks began
lobbying Congress to allow them to enter the
municipal-bond market. In the 1970s, deregulation
allowed brokerage firms to encroach on banking
territory by offering money-market accounts that
pay interest, allow check-writing, and offer
credit or debit cards. In December 1986, the
Federal Reserve Board, which has regulatory
jurisdiction over banking, reinterpreted Section
20 of the Glass-Steagall Act, which bars
commercial banks from being "engaged principally"
in securities business, deciding that banks can
only have up to 5% of gross revenues from
investment banking business. The Fed board then
permitted Bankers Trust, a commercial bank, to
engage in certain CP transactions. In the Bankers
Trust decision, the board concluded that the
phrase "engaged principally" in Section 20 allows
banks to do a small amount of underwriting, so
long as it does not become a large portion of
revenue.
In the spring of 1987, the
Federal Reserve Board voted 3-2 in favor of easing
regulations under Glass-Steagall Act, overriding
the opposition of then-chairman Paul Volcker. The
vote legalized as policy proposals from Citicorp,
JPMorgan and Bankers Trust to allow banks to
handle several underwriting businesses, including
commercial paper, municipal revenue bonds, and
mortgage-backed securities. Thomas Theobald, vice
chairman of Citicorp, had argued that three
"outside checks" on corporate misbehavior had
emerged since 1933 - a very effective Securities
and Exchange Commission (SEC), knowledgeable
investors, and very sophisticated rating agencies
- to render the tight regulations unnecessary.
Yet in the current liquidity crisis, it
has become clear that all three of these "outside
checks" failed in recent years to protect both the
public interest and the orderly function of
markets. The SEC has largely been ineffective in
preventing corporate fraud and market abuse,
investors have been unable to understand fully the
risk of complex financial instruments pushed on
them by confused if not unprincipled brokers, and
rating agencies fell far
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
