Should we separate
banking and investment banking? This is one of the most debated
questions in current discussions about a reorganization of financial
systems around the world. It is also a very polarized discussion –
You are either for or against it, but you will hardly find someone
who is just neutral.
To understand the
discussion, let's first rephrase the question: Traditional banks
receive deposits and make loans (“banking”). Today, banks also
buy and sell securities, mostly corporate stock and bonds
(“investment banking”). Is it better for a society and its
economy to separate these activities or to allow banks to carry them
out altogether?
Second, let's follow the
history of this regulation in the US to understand the prevailing
motivation of the legislator in the different eras.
19th
century – 1927: From a divided to a liberalized financial system
In the 19th century, US
banks could not carry out investment banking (namely holding
corporate stock) and insurance business activities. As a consequence,
they executed these activities in affiliates. These affiliates were
majority owned by banks.
 |
| Arsène Pujo |
At that time, the main
concern about accomplishing both banking and investment banking
activities in a unique corporate structure (= universal banking
model) were the riskiness of holding stocks and the industry's
concentration:
“Enforcing
upon our banking institutions conservatism and confining them to
their legitimate purposes will in any event right itself by the
greater confidence that national banks will enjoy and the business
that will thereby be attracted to them by their greater conservatism
and by reason of the fact that their funds and those of their
depositors, instead of being locked up in fixed investments as the
inevitable result of their engaging in these ventures, will be
available for the current needs of their customers. The enforcement
upon national banks of proper limitations in the use of their funds
will serve also to make them less attractive objects of control by
the great issuing houses, and thus help to check the recent alarming
movement in that direction. When the credit and funds cease to be
available for absorbing the security issues of these houses, the
incentive to domination will cease to exist.”
“National
banks should not be permitted to become inseparably tied together
with security holding companies in an identity of ownership and
management. These holding companies have unlimited powers to buy and
sell and speculate on stocks. It is unsafe for banks to buy and sell
and speculate in stocks. It's unsafe for banks to be united with them
in interest in management. The temptation would be great at times to
use bank's funds to finance the speculative operations of the holding
company. The success and usefulness of a bank that holds the people's
deposits are so dependent on public confidence that it can not be
safely linked by identity of stock interest and management with a
private investment corporation of unlimited powers with no public
duties or responsibilities and not dependent on public confidence.
The mistakes of misfortunes of the latter are too likely to react
upon the former. However profitable the participation of the bank,
whether under the guise of a mere lender of money or underwriter or
purchaser of securities in which the security company is interested,
the incentive to the bank to participate in these adventurous
transactions is one that should be removed beyond the reach of its
officers.
Pujo
Committee Report, February 28, 1913, page 155
 |
| Louis Thomas Mc Fadden |
Despite this restricting
regulation, banks and their affiliates often shared offices. A a
consequence, informal cooperation developed and the separation of
activities eroded over time. In 1927, the Mc Fadden Act gave national
banks explicit authority to buy and sell marketable debt obligations.
1933 – 1970:
Separation of banking and investment banking under the Glass Steagall
Act
After the stock market
crash in 1929 and the following great depression, the Glass Steagall
Act of 1933 again limited the securities dealings of commercial banks
and their affiliates. The legislator thought that banks had fueled
the bubble in the stock market prior to its burst and that securities
dealings were a main driver for banks' failures during the great
depression.
 |
| Carter Glass |
According to its
introduction the legislator intended
“to
provide for the safer and more effective use of the assets of banks,
to regulate interbank control, and to prevent the undue diversion of
funds into speculative operations.”
The main provisions about
a separation of banking and investment banking in the Glass Steagall
Act read like this:
“For
any person, firm, corporation, association, business trust, or other
similar organization, engaged in the business of issuing,
underwriting, selling, or distributing, at wholesale or retail, or
through syndicate participation, stocks, bonds, debentures, notes, or
other securities, to engage at the same time to any extent whatever
in the business of receiving deposits subject to check or to
repayment upon presentation of a passbook, certificate of deposit, or
other evidence of debt, or upon request of the depositor.”
 |
| Henri B. Steagall |
“No
officer or director of any member bank shall be an officer, director,
or manager of any corporation, partnership, or unincorporated
association engaged primarily in the business of purchasing, selling,
or negotiating securities, and no member bank shall perform the
functions of a corresponding bank on behalf of any such individual,
partnership, corporation, or unincorporated association and no such
individual, partnership, corporation, or unincorporated association
shall perform the functions of a correspondent for any member bank or
hold on deposit any funds on behalf of any member bank, unless in any
such case there is a permit therefor issued by the Federal Reserve
Board.”
In 1956, the Bank Holding
Company Act went a step further and prohibited bank holding companies
from engaging in almost all non-banking activities. Only owning bank
premises, performing safe-deposit services, collecting debts, holding
securities in fiduciary capacity, trading in high grade investments,
and holding a trading portfolio of maximum 5 % of total consolidated
assets were still allowed.
The reasoning of that
time is well summarized in the following quote from the Duke Law
Journal:
“There
was the obvious possibility that funds placed on deposit with the
holding company's banking subsidiaries might be employed by the
company to gain advantages in the operation of non-banking interests.
Also, it was feared that the extension of credit could be conditioned
upon the borrower's patronization of these non-banking subsidiaries.”
1970 – 1999: The
Liberalization of the US Banking Sector
In the 1970s, legislation
began to weaken again, as activities “closely related to
banking” were allowed to be carried out by banks. In the 90s,
the discussion about a liberalization of the US financial sector
gained momentum.
 |
| E. Gerald Corrigan |
For example, E. Gerald
Corrigan, a main supporter of liberalization, said in the US congress
in 1991:
“Whether
you like it or not, we are going to see an important degree of
consolidation in the U.S. Banking and financial system. That result,
as I am prone to say, is already “baked in the cake”. The
question, therefore, is not whether that process of consolidation
will occur, but rather whether it will occur the hard way or the easy
way and whether it will occur in a manner that is consistent with the
public interest. […] Whatever else may be said of these changes,
they will over time, work in the direction of permitting institutions
to better diversify their risks and their sources of income. This is
important because when we look for common denominators among
institutions that have failed, one (other than poor judgment and
management) that stands out time and again is concentrations of
activities and credit exposures. In this regard, it should be
stressed that over time, the benefits of diversification of risk and
income flows that would follow from these structural changes would
not accrue solely to banking institutions.”
And, in 1995, Frederick
S. Carns wrote:
“Well-managed
banking organizations currently face artificial obstacles to
diversifying appropriately and maximizing returns for their
shareholders; these institutions are likely to become safer and more
competitive with expanded powers, potentially benefiting consumers as
well as shareholders and taxpayers. Poorly managed institutions, on
the other hand, likely will suffer the consequences of a new set of
poor choices if expanded powers become available, and many of these
firms will fail. […] While banking organizations may be larger and
fewer under two-window system, they also may be better diversified.
Thus, while any given bank failure under this system may be more
costly and destabilizing, there may be fewer failures.[...] It
appears unlikely that concentrations of power would produce any
serious economic problems.”
 |
| Phil Gramm |
Finally, the Gramm Leach
Bliley Financial Modernization Act of 1999 (“GLB Act”)
established a new framework for affiliations among commercial banks,
insurance companies, and securities firms through financial holding
companies and financial subsidiaries. The new legislation provided
for the possibility to carry out the aforementioned 3 activities
within a financial holding company, i.e. not in the same legal entity
but under an umbrella of a bank holding company.
 | |
| Jim Leach |
The leitmotiv of the GLB
act was
“to
enhance competition in the financial services industry by providing a
prudential framework for the affiliation of banks, securities firms,
insurance companies, and other financial service providers.”
 |
| Thomas J. Bliley |
The law says:
“A
bank holding company may engage in any activity, and may acquire and
retain the shares of any company engaged in any activity, that the
Board, in coordination with the Secretary of the Treasury, determines
(by regulation or order) to be financial in nature or incidental to
such financial activities.” One
criterion for determining the financial nature of an activity was to
“foster effective
competition with any company seeking to provide financial services in
the United States”.
As financial in nature were finally qualified the activities of
“lending; insuring;
financial, investment, and economic advisory services; issuing or
selling [financial securities]; underwriting, dealing, and market
making in [financial securities].”
After the 2008 financial
crisis, the Dodd Frank Act of 2010 again reversed the legal
situation. The act's intention is
“to
promote the financial stability of the United States by improving
accountability and transparency in the financial system, to end ‘‘too
big to fail’’, to protect the American taxpayer by ending
bailouts, and to protect consumers from abusive financial services
practices.”
 |
| Chris Dodd |
Its Section 619 prevents
a banking entity from engaging in proprietary trading or acquiring
any ownership interest in a hedge fund or a private equity fund.
However, banks can still
- buy and sell securities issued by the United States and related public entities;
- underwrite and carry out market making activities in financial securities if these activities are driven by reasonably expected near-term demands of clients;
- carry out risk-mitigating hedging activities;
- buy and sell securities on behalf of customers;
- invest in small business investment companies;
- invest in insurance companies;
- organize and offer a private equity or hedge fund;
- conduct proprietary trading abroad and in a separate legal entity;
- run hedge funds and private equity funds outside the US.
 |
| Barney Frank |
In summary, the history
of US banking regulation on a suitable banking model is a back and
forth between enhancing competition in the financial sector through
its liberalization and restraining the banks' scope of intervention
to avoid “too big to fail” situations and taxpayer bailouts. The
challenge is obviously to strike the right balance...
Resources
- Dodd Frank Act 2010
- Bernard Shull – Financial Modernization Legislation in the United States, October 2000
- Frederic S. Carns, A Two-Window System for Banking Reform in FDIC Banking Review 1995
- Gramm Leach Bliley Act 1993
- E. Gerald Corrigan, Statements to the Congress – July 1, 1991
- Mitchell Berlin – Banking Reform: An Overview of the Restructuring Debate in Federal Reserve Bank of Philadelphia Business Review 1988
- Duke Law Journal 1957 – The Bank Holding Company Act of 1956
