Last week, I followed up Yves Smith’s excellent post on “Why Big Capital Markets Players Are Unmanageable” with “More on why big capital markets players are unmanageable.” I would like to extend the discussion beyond the U.S. border into a look at how the universal banking model abroad encroached on the U.S. banking system and created a response that made the repeal of Glass-Steagall an inevitability. I begin this post with the end of the Bretton Woods system and the beginning of deregulation. These events internationalised finance in a way that made universal banking a desirable business model in the U.S. and ended Glass-Steagall.
I should note up front that I am not a market pundit that thinks the repeal of Glass-Steagall was a catalyst for the credit bubble and crash. Nor do I think regulatory reform should bring Glass-Steagall back as Paul Volcker seems to argue. Hopefully, this post will help explain why.
Bretton Woods
In July 1944, major nations met in Bretton Woods, New Hampshire to discuss reforms to the international monetary system. What came out of this conference was a system that had the U.S. dollar at its core with the dollar linked to Gold at a value of $35 an ounce. The system was stable only to the degree that the U.S. dollar maintained its value at this level. However, the U.S. started to inflate from the word go, with this inflation taking on greater measure in the 1960s under the”guns and butter” policy of Lyndon Johnson.
The French, under the charge of the sometimes anti-American leader Charles de Gaulle, were the first to balk at the inflation and they started to convert their U.S. dollar holdings to gold. Other nations followed. This led to the closing of the gold window in 1971, which was the formal recognition that the U.S. dollar was a depreciated currency due to money printing of the U.S. government.
Post Bretton Woods changes in American finance
After Bretton Woods ended, inflation soared globally, leading to disintermediation of the traditional banking system. Money market funds and the Eurodollar market came into existence immediately. Other forms of disintermediation for commercial banks followed including the development of the high yield bond market and securitization to name two. The market for oil and currencies took off as the removal of gold backing from the international monetary system introduced volatility into those markets. The net effect of these changes was a reduction in profits in traditional banking in America and a internationalization of the U.S. financial system.
In large part because of these changes, a focus on deregulation was seen as a fix. In academia, the laissez-faire movement had become dominant, with professors like Milton Friedman leading the way. Now, their ideas were moving into markets beginning with the deregulation of brokerage commissions in 1975 and the creative destruction this created. Over the short-term, deregulation was a killer for broker-dealers, upending the brokerage industry, decimating profits at many brokerages and leading to the rise of discount brokerages like Charles Schwab. This also allowed commissions to be low enough for middle class Americans to start participating in the markets and can thus be seen as a democratization of the markets.
But, overall the 1970s were unkind to the finance industry in America. Commercial banks were disintermediated. Broker-dealers were wiped out and large portions of the financial system moved offshore. The result was that American finance increasingly went abroad in search of profits.
The U.K. is next for major changes
Meanwhile the deregulation movement was gathering steam. The U.K. was considered the sick man of Europe in the 1970s and deregulation was seen as a fix. Eventually this led to changes in Britain that were similar to the changes in the U.S., the most significant of which was Big Bang in 1986 when fixed commissions were abolished. As in the U.S., the stockjobbers and stockbrokers were pummelled by deregulation and many went out of business. In my view, this marked the beginning of the global Universal banking model. Here’s why?
The U.K. became a beach head for U.S. banks searching for profit abroad after the collapse of oil prices and the Latin America crisis in the early 1980s. This disintermediated traditional commercial bank lending in western Europe and reduced profits significantly for banks there. The U.K., as part of the European Union since 1973 and the locus of the Eurodollar market, also became the beach head for European universal banks now expanding internationally, in their own effort to increase profits. All of the major U.K. merchant banks were eventually gobbled up – most by foreign universal banks. Remember Barclays de Zoete Wedd, ING Barings, Dresdner Kleinwort Benson, SBC Warburg, Deutsche Moran Grenfell? Only one of these takeovers involved a U.K. domestic bank. In effect, the U.K. was becoming a de facto Universal banking market.
Back in America: New Competition
By the late 1980s and the 1990s, the deregulated atmosphere in the U.S. meant that commercial banks were seeing an erosion of margins in their traditional lines of business. They reached abroad and were burned (see article on ratings downgrades from 1988). So, they successfully lobbied to increase their ability to participate in investment banking (see 1987 NY Times article) and trading (not without problems: Bankers Trust was the most aggressive and trading irregularities were noted as far back as 1988).
By the 1990s, the now internationalised European universal banks were on the prowl in America too (I am ignoring Japan because its banks were forced into retreat during the lost decade). We saw Credit Suisse acquire First Boston, SBC acquire Dillon Read, and Deutsche Bank acquire Banker Trust. Now, we were seeing international universal bank behemoths that had huge balance sheets and huge investment banking and trading operations in America. The American companies felt at a disadvantage because of Glass-Steagall. And, in truth, they were. So, at this point, Glass-Steagall’s repeal was inevitable because the climate in banking had changed. It was much more international and much more of a universal banking model.
Nevertheless, there was ample reason for alarm because deregulation and lack of oversight make for a dangerous combination. Had America moved to a universal banking model with strict oversight like one sees in Canada, perhaps many of the problems of the credit bubble could have been avoided. But, oversight was lax and the regulatory controls that even the Federal Reserve was granted over the mortgage market in 1994 were never used to stop excess in that market. All of this was predicted in 1999. Below is an excerpt from a New York Times story that ran after Glass-Steagall was repealed.Note how many of the lawmakers cited are the same ones in power today.
In the House debate, Mr. Leach said, ”This is a historic day. The landscape for delivery of financial services will now surely shift.”
But consumer groups and civil rights advocates criticized the legislation for being a sop to the nation’s biggest financial institutions. They say that it fails to protect the privacy interests of consumers and community lending standards for the disadvantaged and that it will create more problems than it solves.
The opponents of the measure gloomily predicted that by unshackling banks and enabling them to move more freely into new kinds of financial activities, the new law could lead to an economic crisis down the road when the marketplace is no longer growing briskly.
”I think we will look back in 10 years’ time and say we should not have done this but we did because we forgot the lessons of the past, and that that which is true in the 1930’s is true in 2010,” said Senator Byron L. Dorgan, Democrat of North Dakota. ”I wasn’t around during the 1930’s or the debate over Glass-Steagall. But I was here in the early 1980’s when it was decided to allow the expansion of savings and loans. We have now decided in the name of modernization to forget the lessons of the past, of safety and of soundness.”
Senator Paul Wellstone, Democrat of Minnesota, said that Congress had ”seemed determined to unlearn the lessons from our past mistakes.”
”Scores of banks failed in the Great Depression as a result of unsound banking practices, and their failure only deepened the crisis,” Mr. Wellstone said. ”Glass-Steagall was intended to protect our financial system by insulating commercial banking from other forms of risk. It was one of several stabilizers designed to keep a similar tragedy from recurring. Now Congress is about to repeal that economic stabilizer without putting any comparable safeguard in its place.”
Supporters of the legislation rejected those arguments. They responded that historians and economists have concluded that the Glass-Steagall Act was not the correct response to the banking crisis because it was the failure of the Federal Reserve in carrying out monetary policy, not speculation in the stock market, that caused the collapse of 11,000 banks. If anything, the supporters said, the new law will give financial companies the ability to diversify and therefore reduce their risks. The new law, they said, will also give regulators new tools to supervise shaky institutions.
”The concerns that we will have a meltdown like 1929 are dramatically overblown,” said Senator Bob Kerrey, Democrat of Nebraska.
Clearly Bob Kerrey was wrong and Paul Wellstone was right.
Post-Internet Bubble makes universal banking model complete
Just after this legislation was passed at the peak of the Tech Bubble, the bubble burst. I would argue that the bursting of the bubble was instrumental in completing the transformation in the U.S. to a universal banking model. If you think back to the mid-1990s, there were scores of boutique investment banks concentrating on the technology sector. The ‘Four Horsemen’ of Alex.Brown, Montgomery Securities, Hambrecht and Quist, and Robertson Stephens were the principal actors. When the tech bubble burst, all of them disappeared, gobbled up by large commercial banks.
In effect, the disappearance of the Four Horsemen marked the end of the old Glass-Steagall model. It was only a matter of time before the likes of Morgan Stanley and Goldman Sachs were forced into the universal banking model.
U.S. Banking: Worse after the crisis than before
With the disaster at Lehman Brothers and Bear Stearns, the transformation became complete because Merrill was gobbled up by Bank of America and Goldman and Morgan became banks. Now, I failed to mention that another step commercial banks took to defend the economics of their business was to merge (list of large mergers here on Wikipedia). This, coupled with relaxation of interstate banking laws, has made the U.S. banking system very concentrated. Add in FDIC-enabled takeovers of WaMu and Wachovia and six too big to fail institutions control the roost: Citigroup, JPMorgan Chase, Wells Fargo, Bank of America, Goldman Sachs and Morgan Stanley.
So, ironically, the U.S. banking system is much more prone to systemic risk today than it was a year ago or a decade ago. Moreover, these institutions still have an enormous amount of so-called toxic assets on their balance sheet hidden in Level Three assets (see post “Level Three Assets: banks are hiding the ball on credit writedowns”). These assets have not been written down to reflect present market values. And, many more writedowns from commercial real estate and credit cards, leveraged loans and high yield bonds remain to be taken.
My conclusion, therefore, is that the likely technical recovery toward the end of this year or the beginning of 2010 is a fake recovery. Much underlying systemic weakness remains. Moreover, the U.S. banking system post-crisis is more concentrated and more vulnerable than ever before. Will bringing back Glass-Steagall solve this? No. This post demonstrates that there are forces in the global marketplace that make Glass-Steagall a relic of the 1930s. Nevertheless, a move away from the self-regulatory nonsense of the last generation is warranted. Enforcement of existing regulations, regulation of OTC derivatives and the shadow banking system are all important steps that need to be taken. However, above all, I am most concerned with the concentrated risk in our financial system. I see no other way to reduce this concentration than to break up too big to fail institutions. If you do see another way please feel free to comment.