Fact and Fiction Behind Too Big to Fail

BREAK ‘EM UP!: Creating Systemic TBTF Banks

Most folks outside the financial services industry (and many within) have the mistaken impression that the elimination of Glass-Steagall barriers between investment and commercial banking occurred in one legislative move. The true truth is that the barriers were first eroded by Federal Reserve actions, instigated by big U.S. commercial banks over a decade earlier than the passage of Gramm-Leach-Bliley. The major steps in this history are described below. Looking with 20/20 hindsight, one could easily view this as an assault not only on the global economy, but also on investment banking itself.

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Examining the Government’s Role in the Banking Sector

Creep. Meaning moving forward in small steps so as not to be noticed.

The Federal Reserve took the first measurable step to insert the taxpayer into investment banking’s trading risks back in 1987. Seeming only a tiny step at the time, who would have imagined that it promoted the subsequent growth of risk-taking using financially-engineered products, creating huge entities whose risk activities are so complex even they can’t manage them?

The original intent of Congress was never to back up trading risk through the FDIC guarantee. In fact, Congress passed Glass-Steagall in 1933 and instituted the Federal Deposit Insurance program in 1934 to prevent runs on commercial banks. Runs on commercial bank deposits might force the immediate repayment of loans to meet withdrawals. Loans support the economy. The FDIC taxpayer guarantee was intended only to create confidence in commercial banks to support lending and therefore the economy.

To this day, the borrowers that most need access to commercial bank lending are the smaller businesses which don’t have access to sophisticated capital markets and ordinary citizens who borrow to finance home or car purchases, college education, and other personal needs. In a consumer-driven economy such as this nation’s, these borrowers and the functioning of commercial banks are essential to the health of the economy.

Removal of Glass-Steagall Barriers Started with the Fed

Deregulation of the financial services sector may have commenced during the Reagan administration, led by the Fed, but it proceeded right through the next three administrations, enjoying mostly bipartisan support.

President Reagan appointed Alan Greenspan Chairman of the Federal Reserve in 1987. Starting in that year, from 1987 to 1995 the Fed gradually increased traditional commercial banks’ investment banking powers in two ways. The Fed allowed the commercial banks to underwrite commercial paper and municipal bonds through “Section 20 subsidiaries.” Then they allowed them to underwrite equities and corporate bonds.

At first the Fed limited revenues from these new investment banking trading powers to five percent of the firm’s total revenues. Then the Fed increased the limit to 10%, then in 1995 to 25%. These Fed actions created a huge incentive for large commercial banks to merge. If two large commercial banks merged, they would then be allowed to double their investment banking activities. Soon they were challenging the largest independent investment banks like Goldman Sachs. How could a privately-held investment bank like Goldman Sachs compete with huge, publicly-held commercial banks with the aura of confidence provided by the government guarantee? Goldman was the last investment bank to “go public” in 1999.

In December 2000 President Clinton signed into law the Commodity Futures Modernization Act, essentially protecting over-the-counter derivatives from regulation.

While large commercial banks claimed they were responding to competition from large European banks, which did allow both activities within a single “universal bank” structure, the compensation practices at major investment banks were no doubt a big incentive. Commercial bankers earned much less than investment bankers, due to the FDIC guarantee and the conservative nature and longer time horizon of commercial banking. Investment banking was short-term in both risk and reward. Actually, investment banks didn’t earn much from traditional stock and bond underwriting either, unless they managed the underwriting.

When Glass-Steagall barriers were removed and the investment banking culture took over the largest “commercial” banks, investment bankers became the CEOs and senior managers of the largest systemic banks. More competitors were added to an intensely competitive business and the chase for personal wealth was on.

If the 1980s and 1990s history could be described as the “dating” phase, the passage of the Gramm-Leach-Bliley Act in 1999, which officially removed the barriers, was the marriage. Financial engineering expanded. That’s when the bubble’s growth took off as can be seen in the graph of the Case-Shiller Housing Index, courtesy of Barry Ritholz”s Big Picture blog with a little tinkering by the New York Times. (Click on the link below.)

NYSSASpeech122014ShillerHousingPriceSlide

That’s a lot of wealth creation and destruction in a short period. Those who were trading on it, in the middle between those who have money and those who need it, were reaping great rewards. They collected the tolls on the superhighway of risk.

The new type of regulation, promised to Congress by Alan Greenspan when he testified in favor of Gramm-Leach-Bliley (at least twice) never materialized. He argued that the banks were already trading securities. Well, yes. Because the Fed permitted it.

The playing field among Goldman Sachs, JPMorgan Chase, and Morgan Stanley was made more uneven by government action. Mr. Picketty, here’s an example of your arbitrary and unsustainable inequality goosing the return on some people’s capital. This was man-made — because the Fed and Congress allowed it. Humans need to reverse it.

 

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Fairy Tale Capitalism: Fact and Fiction Behind Too Big to Fail

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Was the mortgage debacle the sole cause of the financial bubble's collapse? Do you believe those who say the elimination of Glass-Steagall barriers didn't contribute to its building? Fairy Tale Capitalism: Fact and Fiction Behind Too Big To Fail places the mortgage mess into a broader perspective. It explains how the Federal deposit guarantee was married to investment banking's trading intensity, why the Fed had no choice but to bail out the biggest banks and how derivatives played a poorly-understood, but equally important role in the crisis. In simple terms Emily Eisenlohr walks with those who live on Main Street down Wall Street's darker alleys.

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