Of all the discussions that are occurring about the financial crisis and how to not only solve it but ensure it doesn’t happen again, I have noticed a lack of discussion of one already proven method. I believe that congress needs to reinstate portions of the Glass-Steagall Act, specifically the Banking Act of 1933. This legislation forced the separation of Commercial Banks and Investment Banks into two separate entities. There is enough evidence to suggest that this partition is necessary, and two clear examples in recent history of the disasters caused when it is removed. After the jump I will explain why this separation was a key component in successful regulation of the market, and why its repeal, heralded as a success of Free Market Capitalism, shows a fundamental flaw in that philosophy.
In the interests of full disclosure, I will say that I worked for 3 years as a Personal Banker with Investment Licenses for 2 different banks, one of which is no longer in existence. My job was a direct result of the repeal of the separation provisions of Glass-Steagall by the Gramm-Leach-Bliley Act of 1999. It is in part these experiences that have led me to believe that such a separation is needed again.
Passed in 1933 as a response to factors which caused the Great Depression in the wake of the Crash of ’29 the 2nd Glass-Steagall Act, also called the Banking Act of 1933, forced Commercial Banks (those who dealt with Checking, Savings, Loans, and the like) to become wholly separate entities from Investment Banks (those who dealt with issuing, trading, and managing securities portfolios). This was a key component in restoring the public trust in Commercial Banks, which were failing at an alarming rate, by taking out a major component of market risk from those banks. It was also a key component in making FDIC successful by lessening the chance of failure, thus ensuring there would be enough money in FDIC coffers to bail out depositors at the few institutions that did fail.
This separation created a rather effective system of checks and balances, at least as regards one of the major factors of the financial meltdown: Mortgages and their associated securities such as Mortgage Backed Bonds. At the Commercial Banks, loan officers, underwriters, and supervisors would do a heavy amount of due diligence to minimize the risk of default on loans they made. Understand, they were not doing this due diligence for their own sake; they were doing it so that the loans they made could in turn be sold to a 3rd party, an Investment Bank or an entity like Fannie Mae/Freddie Mac. This 3rd party would also exercise their due diligence to minimize the risk of the loans they purchased, as both entities would securitize these mortgages and sell them on the open market in the form of bonds.
Another way of looking at it is this: If a person borrowed $100,000 at 6% from a bank, that bank is now has $100,000 less capital to loan out, but a guarantee of 6% back for the next 30 years. A bank could go to Fannie/Freddie and offer 3% of the interest over time if Fannie/Freddie paid the $100,000 principal of the loan. If the loan conformed to Fannie/Freddie’s standards of credit score, debt-to-income ratio, down payment, etc. then the deal was done. If it did not conform, the bank would have to go to an independent Investment Bank, maybe offering 4% instead of 3% to offset the additional risk. The Investment Bank would look into the loan as well as the originating Bank’s ratings and history, before doing the deal. Whoever ended up with the loan would then “securitize it”, that is, convert it to 100 Bonds with a $1,000 face value and a 2% yield, and sell on the open market to investors.
This system worked because the separation of the Institutions created a form of regulation based off of self-interest. A Commercial Bank, wanting to sell the bulk of its loans to Fannie/Freddie, knew that it had to verify things like income and assets, because Fannie/Freddie required strict adherence to its “Prime” standards. If it couldn’t, it had to rely on documentation to prove that the loan was sound to an Investment Bank, otherwise the Investment Bank wouldn’t touch it, because the Investment Bank didn’t want a hit to their reputation if it issued Bonds that defaulted. When this system was in place, Sub-Prime made up only about 5% of all lending, because Commercial Banks would have to keep them in house or sell them in very small quantities to Investment Banks.
In the late 90’s, ignoring the mess caused by the S&L scandals, Congress voted to eliminate this separation with the Gramm-Leach-Bliley Act. Citibank, which had lobbied Congress for years to permanently eliminate the separation provisions, became fully merged with Travelers Group to form Citigroup, the first institution in the US since 1933 that combined banking, lending, insurance, and investments under one corporation. Many others would follow, with institutions on both sides seeking mergers or acquisitions to create similar institutions.
At the time, the proponents of Gramm-Leach-Bliley insisted that it was necessary for banks to be able to, using the old disproven neo-con phrase, “…compete in the global marketplace…” as European and Japanese institutions did not have such a separation. They assured Congress that proper regulation and oversight would keep another Crash of ’29 (or S&L Scandal) from happening again. We all know how well this turned out… never trust someone who believes in deregulation and “Free Market” to tell you that government regulation will ensure ethics and honesty. The Bush Era saw underfunding to regulatory bodies like the SEC, all while they were being packed with “Free Market” cronies from the banking industry who weren't interested in enforcing regulation anyway.
What we saw happen is that a loan made by an “Integrated” Bank would be taken directly from its lending arm and securitized by its investing arm with little to no due diligence. Sub-Prime lending shot up to 30% of all loans because a Bank no longer had to worry as much about selling the loan to Fannie/Freddie. A loan division manager would simply hand off anything to his buddy down the hall, an investment division manager, who would securitize them and sell them off as bonds. Bond buyers, relying on ratings and reputation, would be none the wiser... despite the fact that the investment managers were mixing more and more sub-prime mortgages into the bond issues. Everyone would collect a bonus based on volume and go to their vacation homes in the Hamptons. The greed trickled down to the front lines, where individual mortgage brokers and bond agents would use questionable tactics to sell to anyone, knowing that regulation was non-existent and that all their bosses’ cared about was volume.
What we need to do now is urge our Congressmembers and the Obama Administration to take another look at a simple rule that kept one piece of the pie safe for 60 years. Splitting the institutions would also go a long way toward ensuring that we never hear the mantra of “too big to fail” again. It won’t solve the problems we are in now, but it will help prevent them from happening to our children and grandchildren.