Page 4 of 4 CREDIT BUST
BYPASSES BANKS PART 2: Bank deregulation
fuels abuse By Henry C K Liu
short in accurately rating
the true risk embedded in debt instruments they
rate.
Volcker opposes
repeal Paul Volcker (Fed chairman 1979-87)
feared that if the easing were approved, banks
would recklessly lower loan standards in pursuit
of lucrative securities offerings and market bad
loans to the public. It was the financial
equivalent of letting the camel's foot
into
the tent. But he was outvoted and since then, the
history of finance capitalism has been the triumph
of the security industry's aggressive culture of
risk over the banking industry's prudent culture
of security.
In March 1987, the Fed
approved an application by Chase Manhattan to
engage in underwriting commercial paper. While the
board remained sensitive to concerns about mixing
commercial banking and underwriting, it
reinterpreted the original congressional intent by
focusing on the words "principally engaged" to
allow for some securities activities for banks.
The Fed also indicated that it would raise the
limit from 5% to 10% of gross revenues at some
point in the future to increase competition and
market efficiency.
Greenspan supports
repeal In August 1987, Alan Greenspan, a
director of JPMorgan and a proponent of banking
deregulation, was appointed chairman of the
Federal Reserve board. Greenspan put the full
power of his new position toward advocating bank
deregulation by asserting its necessity to help US
banks become global financial powers in the
context of the US push for financial
globalization.
In January 1989, the Fed
board approved a joint application by JPMorgan,
Chase Manhattan, Bankers Trust, and Citicorp to
expand the Glass-Steagall loophole to include
dealing in debt and equity securities in addition
to municipal securities and commercial paper. This
marked a large expansion of the activities
considered permissible under Section 20, because
the revenue limit for underwriting business was
still at 5%. Later in 1989, the board issued an
order raising the limit to 10% of revenues,
referring to the April 1987 order for its
rationale.
JPMorgan jumpstart In
1990, JPMorgan became the first bank to receive
permission from the US Federal Reserve to
underwrite securities, so long as its underwriting
business does not exceed the 10% revenue limit. In
1984 and 1988, the Senate passed legislation that
would ease major restrictions under
Glass-Steagall, but in each case the more populist
House of Representatives blocked passage.
In 1991, the administration of president
George H W Bush put forward a proposal for repeal
of Glass-Steagall, winning support of both the
House and Senate banking committees, but the House
again defeated the bill in a full vote. Again in
1995, the House and Senate banking committees
approved separate versions of legislation to
repeal Glass-Steagall, but conference negotiations
on a compromise fell apart.
Attempts to
repeal Glass-Steagall typically pit insurance
companies, securities firms, and large and small
banks against one another, as factions of these
industries engage in turf wars in Congress over
their competing interests and over whether the
Federal Reserve or the Treasury Department and the
Comptroller of the Currency should be the primary
banking regulator.
In December 1996, with
the vocal public support of chairman Alan
Greenspan, the Federal Reserve board issued a
precedent-shattering decision permitting bank
holding companies to own investment bank
affiliates with up to 25% of their business
in securities underwriting, up from 10%. This
expansion of the loophole initially created by the
Fed's 1987 reinterpretation of Section 20 of
Glass-Steagall in effect rendered the act
obsolete, in view of explosive growth of banking.
Virtually any bank holding company wanting to
engage in securities business would be able to
stay under the 25% limit on revenue, since banks
are much larger institutions as compared with
security firms. However, the law remained on the
books and, along with the Bank Holding Company
Act, continued to impose other restrictions on
banks, such as prohibiting them from owning
insurance-underwriting companies.
In
August 1997, the Fed further eliminated many
restrictions imposed on "Section 20 subsidiaries"
by the 1987 and 1989 orders. The board stated that
the risks of underwriting had proved to be
"manageable" and allowed banks the right to
acquire securities firms outright. In 1997,
Bankers Trust, now owned by Deutsche Bank, bought
the investment bank Alex Brown & Co, becoming
the first US bank to acquire a securities firm.
The demise of Glass-Steagall In
February 1998, Sandy Weill of Travelers Insurance
approached Citicorp's John Reed on a merger. The
transaction had to work around remaining
regulations in the Glass-Steagall and Bank Holding
Company acts governing the industry, which were
implemented precisely to prevent a merger of
insurance underwriting, securities underwriting,
and commercial banking. The pending merger in
effect gave regulators and lawmakers three
options: end these restrictions, scuttle the deal,
or force the merged company to cut back on its
consumer offerings by divesting any business that
fails to comply with the law.
The Fed gave
its approval to the Citicorp-Travelers merger on
September 23. The Fed's press release indicated
that "the board's approval is subject to the
conditions that Travelers and the combined
organization, Citigroup Inc, take all actions
necessary to conform the activities and
investments of Travelers and all its subsidiaries
to the requirements of the Bank Holding Company
Act in a manner acceptable to the Board, including
divestiture as necessary, within two years of
consummation of the proposal ... The Board's
approval also is subject to the condition that
Travelers and Citigroup conform the activities of
its companies to the requirements of the
Glass-Steagall Act."
After the merger
announcement on April 6, 1998, Weill immediately
launched a lobbying and public relations campaign
for the repeal of Glass-Steagall and passage of
new financial services legislation known as the
Financial Services Modernization Act of 1999.
"Modernization" was a euphemism for total
deregulation for the brave new world of financial
globalization.
The House Republican
leadership wanted to enact the measure in the
current session of Congress. While the
administration of then president Bill Clinton
generally supported Glass-Steagall
"modernization", there were concerns that mid-term
elections in November could bring in new Democrats
less sympathetic to changing the populist laws. In
May 1998, the House passed legislation by a narrow
vote of 214-213 that allowed the merging of banks,
securities firms, and insurance companies into
huge financial conglomerates. And in September,
the Senate Banking Committee voted 16-2 to approve
a compromise bank-overhaul bill. Despite this new
momentum, Congress was still not certain to pass
final legislation before the end of its session.
As the final push for new legislation
heated up around election time, lobbyists raised
the issue of financial modernization with a fresh
round of political fundraising. Indeed, in the
1998 mid-term election, the finance, insurance,
and real-estate industries, known as the FIRE
sector, built a bonfire of more than $200 million
on lobbying and more than $150 million in
political donations. Campaign contributions were
targeted to members of congressional banking
committees and other committees with direct
jurisdiction over financial-services legislation.
After 12 attempts in 25 years, Congress
finally repealed Glass-Steagall, rewarding
financial companies for more than 20 years and
$300 million worth of lobbying efforts. Supporters
hailed the change as the long-overdue demise of a
Depression-era relic. Opponents saw it as the root
of a future depression.
Repeal leads to
current credit crisis What nobody expected,
not even the most fervent opponents to bank
deregulation, was that the repeal of
Glass-Steagall would pave the way to the emergence
of the non-bank financial system, which took off
like a fighter jet off the deck of an aircraft
carrier with the advent of deregulated global
financial markets, which eventually rendered both
banks and their central-bank lenders of last
resort irrelevant in a brave new world of finance.
Just days after the US Treasury Department
signed on to support the repeal of Glass-Steagall,
treasury secretary Robert Rubin, a former
co-chairman of Goldman Sachs, accepted a top
position at Citigroup as vice chairman. The
previous year, Weill had called Rubin to give him
advance notice of the upcoming merger
announcement. When Weill told Rubin he had some
important news, the secretary reportedly quipped,
"You're buying the government?" Rubin could have
added: "With debt?" The answer, while never
reported, could have been: "No, the whole world."
The world that Weill bought with debt from
the non-bank financial system is now in a severe
credit crisis with an irrelevant banking system
that needs to have $1.3 trillion put back into the
banks' balance sheets. Even if the Fed bails out
the banks by easing bank reserve and capital
requirements to absorb that massive amount, the
raging forest fire in the non-bank financial
system will still present finance capitalism with
its greatest test in eight decades.
Cash
may be king in a liquidity crisis, but in a credit
crisis, a king may echo William Shakespeare's
Richard III: "A horse, a horse, my kingdom for a
horse."
This is the final article of a
two-part analysis.
Henry C K Liu is
chairman of a New York-based private investment
group and visiting professor of global development
in the economics department of the University of
Missouri at Kansas City. His website is at
www.henryckliu.com.
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