Tuesday, September 16, 2008

Looking through the Glass-Steagall repeal

Guambat reckons the Bush administration has readily aided and abetted this financial market blow-up. If not by direct intervention, by putting people in places of responsibility who shunned it, or worse, shackled it. People like Harvey Pitt who, when put in charge of the SEC, felt Mr. Market would make better a regulator, so deferred.

But lets not get partisan. The Gramm-Leach-Bliley Act was a product of Bill Clinton's administration, and marked the pivot point where government of the financial markets shifted from consumer protection to market protection.

For background, Guambat turns to Investopedia.com, What Was The Glass-Steagall Act?, a product of Forbes, a product of the conservative Forbes family, Guambat suspects.
In 1933, in the wake of the 1929 stock market crash and during a nationwide commercial bank failure and the Great Depression, two members of Congress put their names on what is known today as the Glass-Steagall Act (GSA). This act separated investment and commercial banking activities. At the time, "improper banking activity", or what was considered overzealous commercial bank involvement in stock market investment, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors' money.

Commercial banks were accused of being too speculative in the pre-Depression era, not only because they were investing their assets but also because they were buying new issues for resale to the public. Thus, banks became greedy, taking on huge risks in the hope of even bigger rewards. Banking itself became sloppy and objectives became blurred. Unsound loans were issued to companies in which the bank had invested, and clients would be encouraged to invest in those same stocks.

Steagall agreed to support the act with Glass after an amendment was added permitting bank deposit insurance (this was the first time it was allowed).

As a collective reaction to one of the worst financial crises at the time, the GSA set up a regulatory firewall between commercial and investment bank activities, both of which were curbed and controlled. Banks were given a year to decide on whether they would specialize in commercial or in investment banking. Only 10% of commercial banks' total income could stem from securities....

Financial giants at the time such as JP Morgan and Company, which were seen as part of the problem, were directly targeted and forced to cut their services and, hence, a main source of their income. By creating this barrier, the GSA was aiming to prevent the banks' use of deposits in the case of a failed underwriting job.

The GSA, however, was considered harsh by most in the financial community....

Despite the lax implementation of the GSA by the Federal Reserve Board, which is the regulator of U.S. banks, in 1956, Congress made another decision to regulate the banking sector. In an effort to prevent financial conglomerates from amassing too much power, the new act focused on banks involved in the insurance sector. Congress agreed that bearing the high risks undertaken in underwriting insurance is not good banking practice. Thus, as an extension of the Glass-Steagall Act, the Bank Holding Company Act further separated financial activities by creating a wall between insurance and banking. Even though banks could, and can still can, sell insurance and insurance products, underwriting insurance was forbidden.

The limitations of the GSA on the banking sector sparked a debate over how much restriction is healthy for the industry. Many argued that allowing banks to diversify in moderation offers the banking industry the potential to reduce risk, so the restrictions of the GSA could have actually had an adverse effect, making the banking industry riskier rather than safer. Furthermore, big banks of the post-Enron market are likely to be more transparent, lessening the possibility of assuming too much risk or masking unsound investment decisions. As such, reputation has come to mean everything in today's market, and that could be enough to motivate banks to regulate themselves.

Consequently, to the delight of many in the banking industry ..., in November of 1999 Congress repealed the GSA with the establishment of the Gramm-Leach-Bliley Act, which eliminated the GSA restrictions against affiliations between commercial and investment banks. Furthermore, the Gramm-Leach-Bliley Act allows banking institutions to provide a broader range of services, including underwriting and other dealing activities.

Although the barrier between commercial and investment banking aimed to prevent a loss of deposits in the event of investment failures, the reasons for the repeal of the GSA and the establishment of the Gramm-Leach-Bliley Act show that even regulatory attempts for safety can have adverse effects.
Guambat will just let that bit of historical perspective speak for itself.

And as far as the 1956 legislative action taken "to prevent financial conglomerates from amassing too much power", Guambat points out that of the 5 largest independent investment banks in the US at the beginning of this year, only 2 exist today: Bear Stearns, Lehman and Merrill Lynch are toast.

Bear Stearns was, of course, lathered in Fed money for jam and savoured by commercial bank JP Morgan, whose predecessor was one of the giants of the time that led to the enactment of Glass-Steagall in the first place. And so, like Alice, we have come backward through the looking glass.

An interesting aside is that, about that time, the Bank of America, which yesterday scarfed down Merrill Lynch, had cast off its Bank of Italy moniker and was expanding from the small Italian community in North Beach San Francisco under the commanding hand of its immigrant founder, A.P. Giannini, an irrepressible man whose Transamerica Corporation later also came into regulator's sights, for a while, at least.

Floyd Norris' NYT blog has a slightly different angle. Looking for "lessons" from the current debacle, which Guambat reckons were already learned and forgotten last century, he observes,
1. The capital rules were far too lax, and they still are. They may have made sense if you assumed perfectly liquid and smoothly functioning markets, but that is like saying a roof does not leak when it is sunny and mild.

2. The end of the rules separating commercial banks from investment banks — Gramm Leach Bliley — is one reason the government is much more deeply involved now. Bank of America and J.P. Morgan Chase, the fire-sale buyers of Merrill and Bear, have government guaranteed deposits. That amounts to a subsidy, and when times get tough the subsidized firm has a big advantage over the unsubsidized one. To keep the others going, the Fed now will lend them money secured by almost anything they can find, including common stocks.

3. Those who were complaining, only months ago, that excessive regulation was making American markets uncompetitive, had it exactly wrong. It was a lack of regulation of the shadow financial system and its players that allowed this to happen. The regulators might not have gotten it right if they had tried to put limits on leverage, or assure that it was clear what risks were being taken, in the world of derivatives and securitizations. But deciding not to even try, and assuming that risks traded secretly would somehow end up in the hands of those most able to bear them, reflected ideology, not analysis.


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