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Too Big to Fail (Which Idiot Decided to Repeal Glass-Steagall?)

February 22nd, 2009 by selise

Behind the debates over future policy is a debate over history—a debate over the causes of our current situation. The battle for the past will determine the battle for the present. So it’s crucial to get the history straight.

— Joseph Stiglitz, 2009 in Vanity Fair


In a previous post on OTC Derivatives (Which Idiot Decided Not to Regulate Credit Default Swaps?) we looked at the legislative history of the Commodity Futures Modernization Act of 2000. Today the topic is the Gramm-Leach-Bliley Act and the repeal of Glass-Steagall—a part of the deregulation story of how our banks got "too big to fail." For additional details and reference links see my Financial Regulation Timeline webpage.

From Stiglitz’s 2003 book, The Roaring Nineties (typos are mine):

For more than half a century, commercial banking, which takes deposits from households and firm and makes conventional loans, had been separated from investment banking, which helps firms issue new bonds and shares. The same company could not lend money and also sell securities, in other words. The Glass-Steagall Act, which barred this, was one of the reforms put in place by the administration of Franklin Roosevelt, in response to the wave of bank failures that had followed the Great Crash of 1929. But the ideas behind Glass-Steagall went back even further, to Teddy Roosevelt and his efforts to break up the big trusts, the large firms that wielded such economic power. TR and the Progressives of the early twentieth century were alarmed not only about the concentration of economic power but about its impact on the political process. When enterprises become too big, and interconnections too tight, there is a risk that the quality of economic decisions deteriorates, and the "too big to fail" problem rears its ugly head. Expecting to be bailed out of trouble, managers become emboldened to take risks that they might otherwise shun. In the Great Depression, when many banks were on the ropes, it was, in effect, the public that bore the risk, while the bank got the reward. Wen banks failed, the taxpayers paid the price through publicly funded bailouts.

The Glass-Steagall Act of 1933 addressed a very real problem. Investment banks push stocks, and if a company whose stock they have pushed needs cash, it becomes very tempting to make the loan. The U.S. system worked in part because under Glass-Steagall the banks provided a source of independent judgments on the creditworthiness of businesses. When a "full-service" bank makes most of its money by selling equities and bonds or arranging "deals," issuing loans becomes almost ancillary—a sideline.

With Glass-Steagall, the United States rejected the course followed by other nations, such as Japan and Germany, that did not separate commercial and investment banking—I believe to our evident benefit. But American banks themselves saw Glass-Steagall as reducing their opportunities for making profits and not surprisingly began to insist that the rules separating commercial and investment banking had become passé. In an age of free-floating capital and giant multi-national companies, they argued, banks had to be integrated, to make advantage of what are called "economies of scope"—the benefits that businesses can reap by working in many different areas at once. Global competition was too intense for bank concentration to be a serious worry (though in fact, many borrowers, especially small and medium-siaze firms, have access only to a few potential lenders), and Glass-Steagall supposedly put American banks at a disadvantage.

In the mid-nineties, the banks mounted a concerted campaign to have Glass-Steagall repealed. The conditions were favorable. Prosperity made the notion of bank failure seem very remote (though the S&L crisis of the eighties ought to have been a caution).

In late 1986 and early 1987 Glass-Steagall restrictions on commercial banks were beginning to be successfully challenged in the courts, with the New York State Banking Department and with the Federal Reserve. At the end of April and again in May 1987 the Federal Reserve Board voted 3-2 to permit commercial banks to engage in some limited securities underwriting over the objections of Fed Chairman Paul Volcker who opposed the change. In June, soon after Alan Greenspan publicly backed the Treasury Department’s new position on the creation of a few very large banks, the Reagan administration announced its choice of Greenspan to replace the retiring Volcker.

Top officials at the Treasury Department have concluded that the Government should encourage creation of very large banks that could better compete with financial institutions in Japan and Europe.

The Treasury plan, which would permit the acquisition of banks by large industrial companies, was also endorsed by Alan Greenspan, in an interview before President Reagan nominated him this week to be chairman of the Federal Reserve Board.

Formation of such large banks has been hampered by two of the nation’s principal banking laws: the Glass-Steagall Act of 1934, which separates underwriting and commercial banking, and the Bank Holding Company Act of 1956, which prohibits nonbanking companies from owning banks.

In the Administration, the hope is that Congress can be persuaded to loosen the regulations. The banking industry, which has considerable political influence, is divided: The largest banks strongly support the changes while smaller banks fear they would be put out of business.

The Reagan Administration has met frustration in its efforts to lessen regulation of banking, largely because Paul A. Volcker, the current Federal Reserve chairman, has firmly opposed any move that would begin to break down the barriers that prohibit large nonbanking companies from owning banks.

But after Mr. Volcker departs in August, the Federal Government’s major regulators will be speaking with a nearly unified voice. Both Robert L. Clarke, Comptroller of the Currency, and L. William Seidman, chairman of the Federal Deposit Insurance Corporation, support in principle the Gould approach, as do several Fed governors.

In the interview, Mr. Greenspan said ”the separation of commerce and banking at this stage is simply not helpful” because it cuts off one important source of new capital. He added that the declining profits of the leading American banks had hampered their ability to raise capital in stock offerings. That leaves them only one practical source for large injections of funds: the industrial sector of the economy.

Given the current banking environment, Mr. Greenspan said, ”I do not have a fear of undue concentration of banking powers.”

Volcker continued to oppose the expansion of banks into the securities underwriting business until his retirement in August 1987 when Alan Greenspan was sworn in as Chairman of the Federal Reserve. But at this time there was still support for Glass-Steagall in Congress (even from Schumer who wrote an oped for the NYT, Don’t Let Banks Become Casinos) and so, even with Greenspan at the Fed continuing to advocate for repeal, the most Citicorp and others could do was to chip away at regulations. Over the years several attempts were made to change the law but failed to win passage in Congress. It would take a Republican Congress and the Clinton administration’s Robert Rubin and Larry Summers at Treasury to finally repeal Glass-Steagall.

In January of 1995, Robert Rubin became Treasury Secretary. Before joining the Clinton administration, Rubin had worked for 26 years at Goldman Sachs. In March, Rubin asked Congress to repeal the Glass-Steagall Act and to change the Bank Holding Company Act of 1956. Several hearings were held on Representative James A. Leach’s H.R.1062 ("Financial Services Competitiveness Act of 1995" to modernize Glass-Steagall) but the bill died in committee.

In April of 1998, Citicorp (banking) and Travelers Group (insurance) announced their supermerger. Although in violation of Glass-Steagall Act and the Bank Holding Company Act, a temporary waiver delayed required divestitures for two years and chairmen Sandy Weill and John Reed indicated that they intended to pursue changing the law rather than divestiture. Citibank spent "$100 million on lobbying and public relations" in the year prior to repeal.

On January 6, 1999, Leach introduced H.R.10, the Financial Services Act of 1999, and the push for repeal was on for the 106th Congress. That spring, the House Banking and Financial Services committee, chaired by Leach, the Senate Banking committee, chaired by Senator Phil Gramm, and the House Commerce committee, chaired by Representative Tom Bliley, held a total of 8 days of hearings. On April 28, 1999, Gramm introduced S.900, the Senate’s version of H.R.10 and it passed 54-44 on May 6. H.R.10 was passed in the House by 343-86 on July 1. Although there was general agreement on the main points, significant controversy remained regarding whether the Fed or Treasury should have the primary regulatory role and on proposed exemptions to the Community Reinvestment Act.

On July 2, 1999, Rubin retired and Larry Summers became Treasury Secretary. In October Rubin joined Citigroup where he would eventually be paid over a $115 million.

On July 20, 1999 the House amended S.900 with the contents of their own bill and then the House and Senate sent it conference committee on the 30th where it remained for almost 2 months with no action taken. Reporting on the conference negotiations in the LA Times on November 2, 1999, Robert Scheer wrote:

Only last week, as the bill was being pushed through a congressional conference committee, Treasury Secretary Lawrence H. Summers rushed back from a trip to China to huddle with lobbyists representing Citigroup, Goldman Sachs, Merrill Lynch and other financial giants. The meeting was closed to the media and public, but one participant told the New York Times that Summers lectured the lobbyists on how to spin this bill so it appears to be in the public interest. "He said it would be very unfortunate if any financial institution were to suggest that they do not see the broad public purpose of this legislation," the lobbyist reported.

Finally, during the first week of November, S.900, the Gramm-Leach-Bliley Act, was reporting out of committee and passed in the Senate 90-8 and in the House 362 – 57. Glass-Steagall was finally repealed and Democrats as well as Republicans celebrated.

And now, more than 20 years after the Volcker lost his battle to protect Glass-Steagall, where are we? Here’s a clue from Yves Smith at naked capitalism: Another Sign That Volcker is Marginalized (And a Preview of His Program)

Last week. Bloomberg reported that Volcker, who many regard as the best asset on Obama’s economics team, is sorely underutilized:

Paul Volcker has grown increasingly frustrated over delays in setting up the economic advisory group President Barack Obama picked the former Federal Reserve chairman to lead…

Volcker, 81, blames Obama’s National Economic Council Director Lawrence Summers for slowing down the effort to organize the panel of outside advisers….Summers isn’t regularly inviting Volcker to White House meetings and hasn’t shown interest in collaborating on policy or sharing potential solutions to the economic crisis,

The usual denials ensued. But a story that corroborates this picture comes from the Globe and Mail, courtesy reader Marshall. Volcker is very much in favor where bank do the bulk of credit intermediation and focus on traditional lending. Effectively, he is calling for the re-imposition of Glass Steagall, the Depression-era legislation that separated commercial banking from investment banking. As we discuss below, this is a radical idea and is at odds with the program Geithner announced earlier this week…

x-posted at oxdown


Note: This is part 3 of a series on the (mostly) legislative history of financial deregulation that has contributed to our current financial and economic crisis. For the entire series, including the timeline (where most of the reference links are), see the Financial Regulation Timeline page. Please use the comments to contribute links and other information. Thanks, selise.

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