Thursday, February 28, 2013

Should Banks deal with Securities? The History of US Banking Regulation


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.”
Pujo Committee Report, February 28, 1913, page 153

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...



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