Wednesday, April 30, 2008

Bring back Glass Steagall

The Great Depression brought about many needed regulatory reforms. These acts served to curb excess speculation, and to keep the funds of bank depositors safe. One of the primary reasons for the insolvency of many commercial banks in the 1930s was the loaning of money for stock market speculation in a market that allowed absurd levels of leverage. Many of these banks owned brokerage security operations, and found an easy path to executive riches by pressing these loans on depositors prior the 1929 crash.

The Glass-Steagall Act tamed this circus by prohibiting banks from owning financial companies. This created a wall that stopped the ridiculous activities of banks that were not in the best interest of customers. Coupled with the creation of the FDIC and other reforms included in the act, the Glass-Steagall legislation protected both bank account customers and investors. The act prohibited a commercial bank from offering investment and insurance services while maintaining better regulatory scrutiny on capital ratios.

Unfortunately, the provisions that separated cross-ownership were over-turned by the Gramm-Leach-Bliley Act of 1999. Financial companies spent more than $300 million in lobbying over 20 years in their attempts to repeal Glass-Steagall.

Not merely content to simply mine the riches offered by the combination of insurance underwriting, securities underwriting, and commercial banking; Wall Street championed unregulated derivatives. The securities industry claimed that these contracts would distribute risk and regulating derivatives would impede economic development. Supported by the Federal Reserve the merged financial industry drove the wide-scale introduction of derivatives into traditional commercial banking markets such as mortgages.

Since 1999, the derivatives have grown on a parabolic curve. There are now over $516 trillion in derivatives outstanding.

In a short eight years, the rapid proliferation of derivative contracts has become the Trojan horse that is likely to undermine the entire modern banking system. The collapse of Bear Stearns should act as a warning for the entire financial market. It is time for regulators to step in and properly unwind the most troubled instruments, while providing concrete oversight to the entire derivatives industry. Obviously the lunatics have been found unfit to run the derivative financial asylum. Deregulation has run amok, and financial checks and balances must be restored to protect the economies of major nations.

Investment banks’ culture of risk is diametrically opposed to the purpose of commercial savings banks which is the preservation of customers’ assets. The introduction of derivatives as the primary under-pinning for the mortgage industry with little regulatory oversight was an event that was obviously going to end in a calamity; similar to giving liquor and a car to a chronic drunk.

The continuous reduction of the protections of Glass-Steagall, by politicians in Washington driven by banking PAC money, is the root cause of the current painful credit crunch which is undermining the entire U.S. economy. In order to fix the core problems, the protections created by Glass-Steagall after the harsh lessons of the Great Depression must be restored by Congress. A clear separation of commercial and investment banking must be reestablished.

A recent PBS Frontline outlined The Long Demise of Glass-Steagall.