Conclusion

A new Glass-Steagall Act would break up universal banks and end the conflicts of interest that prevent universal banks from acting as objective lenders and impartial investment advisers. It would produce a more stable and resilient financial system by reestablishing structural buffers to prevent contagion between the banking system and other financial sectors. It would improve market discipline by preventing banks from transferring their safety net subsidies to affiliates engaged in capital markets activities. It would shrink the shadow banking system by prohibiting nonbanks from issuing short-term financial claims that function as deposit substitutes. It would remove the dangerous influence that large financial conglomerates exercise over our political and regulatory systems. It would end the current situation in which our financial system and our economy are held hostage to the survival of universal banks and large shadow banks. It would restore our banking system and financial markets to their proper roles as servants—not masters—of nonfinancial business firms and consumers.

Origins

Chapter 1 describes the rise of universal banks in the U.S. during the late nineteenth and early twentieth centuries. Large commercial banks in New York and Chicago entered the securities business in the late nineteenth century by forming alliances with leading investment banks. In 1902, the federal regulator of national banks (the Comptroller of the Currency) told national banks that they could not underwrite or trade in securities except for government bonds. Large national banks evaded that prohibition by establishing securities affiliates. Securities affiliates of national banks survived challenges from the Justice Department, Congress, and the Comptroller of the Currency between 1911 and 1920. Universal banks and their securities affiliates prospered during the 1920s with the enthusiastic support of the Harding and Coolidge administrations. The survival and growth of universal banks during the early twentieth century demonstrated their ability to overcome political and regulatory obstacles.

Introduction

Universal banks arose in the U.S. during two periods in the past century—the 1920s and the late 1990s. On both occasions, universal banks in the U.S. and Europe promoted intense boom-and-bust cycles that led to global calamities—the Great Depression of the early 1930s and the Great Recession of 2007–09. Universal banks received extensive bailouts on both sides of the Atlantic during both crises. Three core features of universal banks cause them to generate destructive boom-and-bust cycles. First, pervasive conflicts of interest prevent them from acting as objective lenders or as impartial investment advisers. Second, bonus-driven cultures encourage their insiders to take speculative risks to produce short-term profits. Third, their ability to convert loans into asset-backed securities allows them to package risky loans into securities sold as purportedly “safe” investments to poorly informed investors. The Glass-Steagall Act of 1933 broke up universal banks and established structural buffers that prevented spillovers of risk between the banking system and other financial sectors. The U.S. avoided systemic financial crises after World War II until Glass-Steagall was undermined by regulators and ultimately repealed by Congress. Congress failed to adopt similar structural reforms after the Great Recession. As a result, universal banks continue to dominate our financial markets and pose unacceptable systemic dangers. We urgently need a new Glass-Steagall Act to break up universal banks again and restore a more stable and resilient financial system.

Unfinished Business

In 2009, the U.S. and other G20 nations agreed on reforms designed to improve the regulation of systemically important financial institutions and markets. However, those reforms did not change the fundamental structure of the financial system, which continues to be dominated by universal banks and large shadow banks. Those giant institutions are too big, too complex, and too opaque to be effectively managed by their executives or adequately disciplined by market participants and regulators. In addition, government officials have failed to hold top executives accountable for widespread misconduct at financial giants during and after the financial crisis. The extensive networks linking capital markets, universal banks, and shadow banks create a strong probability that serious problems arising in one financial sector will spill over into other sectors and trigger a systemic crisis. Consequently, governments face enormous pressures to rescue universal banks and large shadow banks whenever a financial disruption occurs. There are serious doubts whether many governments and central banks will possess the necessary resources in the future to provide comprehensive bailouts similar to those arranged during the last crisis. Accordingly, the next systemic financial crisis might not be contained and could potentially lead to a second Great Depression.

See No Evil

During the 2000s, universal banks originated and securitized trillions of dollars of toxic subprime loans and sold the resulting debt securities to investors around the world. Governments on both sides of the Atlantic encouraged universal banks to engage in high-risk lending and securitization. Universal banks enjoyed unrivaled influence, and government officials ignored warnings about the dangers of subprime lending from consumer advocates and academics who did not hold “mainstream” views. Policymakers in the U.S. and Europe recognized that many households were becoming more deeply indebted and were relying more heavily on home mortgages and other types of consumer credit to cover their living expenses. Officials tolerated those developments because they viewed housing construction and household consumption as the primary drivers of economic growth in an otherwise challenging environment. The decision by policymakers to rely on housing credit as the main stimulus for economic growth in a period of stagnant incomes had catastrophic results.

Resurgence, Part II

Large banks and their political allies waged a twenty-year campaign to secure legislation that would remove the structural buffers established by the Glass-Steagall and Bank Holding Company Acts. That campaign triumphed in 1999, when Congress passed the Gramm-Leach-Bliley Act (GLBA). GLBA authorized the creation of financial holding companies that owned banks, securities firms, and insurance companies. In 2000, Congress passed the Commodity Futures Modernization Act (CFMA), which exempted over-the-counter derivatives from substantive regulation by the federal government or the states. GLBA and CFMA enabled large U.S. banks to become universal banks for the first time since the 1930s. Large U.S. securities firms responded by becoming shadow banks (and de facto universal banks) through their issuance of deposit substitutes (shadow deposits). Similar patterns of deregulation encouraged the growth of large universal banks in the U.K. and Europe. A group of seventeen U.S., U.K., and European financial conglomerates dominated global financial markets by 2000.

Resurgence, Part I

The Glass-Steagall Act created a decentralized financial system composed of three separate and independent financial sectors—commercial banking, securities markets, and insurance. The Bank Holding Company Act of 1956 reinforced Glass-Steagall’s policy of structural separation by prohibiting bank holding companies from engaging in any activities that were not “closely related to banking.” Glass-Steagall’s structural barriers prevented the occurrence of systemic financial crises for more than four decades. During that period, federal regulators could deal with problems arising in one financial sector without need to rescue the entire financial system. Despite Glass-Steagall’s success, federal agencies and courts undermined its prudential buffers during the 1980s and 1990s by opening loopholes. Those loopholes allowed banks to convert their loans into asset-backed securities and to offer derivatives that functioned as synthetic substitutes for securities and insurance products. Regulators and courts also allowed money market mutual funds and other nonbanks to issue short-term financial claims that served as deposit substitutes, despite Glass-Steagall’s prohibition against deposit-taking by nonbanks.

Nemesis

Banking crises occurred on both sides of the Atlantic during the Great Depression. Troubled universal banks were at the center of each crisis. The first U.S. banking crisis in late 1930 was caused by the failures of two large financial conglomerates. In May 1931, the collapse of Austria’s biggest universal bank triggered a series of crises that swept through Europe. Austria, Germany, Belgium, and Italy took extraordinary measures to rescue their largest universal banks. In the U.S., the Reconstruction Finance Corporation provided loans that prevented the failures of two large universal banks in 1932. However, the RFC allowed the two biggest banks in Detroit to fail in February 1933, thereby precipitating a nationwide banking panic. In contrast, Great Britain and Canada did not experience systemic banking crises despite serious economic downturns. The separation between commercial banks and securities markets in those two nations prevented financial contagion that could have undermined their entire financial systems.

Foreign Affairs

A speculative and unstable credit boom occurred in overseas markets during the 1920s, as universal banks and private investment banks competed aggressively to sell more than $12 billion of foreign bonds to U.S. investors. The resulting surge in overseas lending left many governments and private sector borrowers in Central and Eastern Europe and Latin America in a dangerously exposed position when U.S. investors lost their appetite for foreign bonds at the end of the 1920s. Universal banks and investment banks sold many unsound foreign bonds to unsophisticated and trusting American investors. The massive sales of risky domestic and foreign securities by universal banks and investment banks had highly adverse effects on the U.S. economy, foreign economies, and investors when the domestic and overseas financing booms abruptly ended following the stock market crash in late 1929.

Frenzy

Large commercial banks and their securities affiliates helped to finance an unsustainable credit boom and stock market bubble during the 1920s. Charles Mitchell of National City Bank and Albert Wiggin of Chase National Bank pioneered a new universal banking (“financial department store”) business model for large commercial banks. The rise of universal banks resulted in frenzied competition between those institutions and private investment banks. That rivalry resulted in the widespread marketing and sale of speculative, high-risk securities to unsophisticated, poorly informed investors. More than $80 billion of debt and equity securities were issued in the U.S. between 1919 and 1930. The easy availability of financing during the 1920s caused many American companies and households to overexpand and take on excessive debts. Those debt burdens left businesses and consumers in a highly vulnerable position when the credit boom suddenly ended in late 1929.