Who could possibly have seen the banking disaster coming?

What was the theory behind the Glass-Steagall Act? Foremost, it was meant to restore a certain sobriety to American finance. In the 1920s, the banker had gone from a person of sober rectitude to a huckster who encouraged people to gamble on risky stocks and bonds. As [chief congressional counsel Ferdinand] Pecora noted, small investors identified banks with security, so that National City salesmen “came to them clothed with all the authority and prestige of the magic name ‘National City.’” It was also argued that the union of deposit and securities banking created potential conflicts of interest. Banks could take bad loans, repackage them as bonds, and fob them off on investors as National City had done with Latin American loans. They could even lend the investors money to buy the bonds. A final problem with the banks’ brokerage affiliates was that they forced the Federal Reserve System to stand behind both depositors and speculators. If a securities bank failed, the Fed might need to rescue it to protect the parent bank. In other words, the government might have to protect speculators to save depositors.

Ron Chernow, The House of Morgan, 1990, pg. 375. (Emphasis added)

 

The repeal of Glass-Steagall was passed by Congress and signed into law by President Clinton in 1999.

The arguments made to repeal the act were primarily

  1. Depository institutions will now operate in “deregulated” financial markets in which distinctions between loans, securities, and deposits are not well drawn. They are losing market shares to securities firms that are not so strictly regulated, and to foreign financial institutions operating without much restriction from the Act.
  2. Conflicts of interest can be prevented by enforcing legislation against them, and by separating the lending and credit functions through forming distinctly separate subsidiaries of financial firms.
  3. The securities activities that depository institutions are seeking are both low-risk by their very nature, and would reduce the total risk of organizations offering them – by diversification.
  4. In much of the rest of the world, depository institutions operate simultaneously and successfully in both banking and securities markets. Lessons learned from their experience can be applied to our national financial structure and regulation

Emphasis added

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