The Glass-Steagall Act and Shadow Banking

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Recently the Federal Reserve announced that it would provide assistance to investment banks, such as Merrill Lynch, Goldman Sachs and Lehman Brothers, as well as commercial banks such as Citibank, Bank of America and Wells Fargo, by exchanging U.S. Treasury securities in the Fed’s portfolio for less-secure securities, including mortgage-backed, in the investment banks’ and commercial banks’ portfolios. Both investment banks and commercial banks benefit if they can swap lower-value securities for higher-value securities.

The investment banks (called shadow banks by those who accuse them of reckless borrowing and lending) now have a benefit previously reserved for commercial banks. That prompted some observers to ask, “Shouldn’t the investment banks be regulated like commercial banks if the Fed extends commercial-bank benefits to the investment banks?”

Today’s New York Times (http://www.nytimes.com/2008/03/29/business/29regulate.html?adxnnl=1&ref=todayspaper&adxnnlx=1206810825-jlYwIO2HagML52mFHEJHwA) began the answer to that question. In an article by Edmund L. Andrews entitled “Treasury Dept. Plan Would Give Fed Wide New Power,” the lead paragraph said:

“The Treasury Department will propose on Monday that Congress give the Federal Reserve broad new authority to oversee financial market stability……..”

The article went on to say:

“While the plan could expose Wall Street investment banks and hedge funds to greater scrutiny, it carefully avoids a call for tighter regulation.”

We’ll see how Congress and the Treasury Department resolve the tension between oversight and regulation. But there’s a historical irony insofar as commercial banking and investment banking activities were both part of regular bank operations – and therefore subject to the Fed’s control - until the Glass-Steagall Act separated them in 1933. The objective: Make commercial banks safer by forbidding them to engage in investment banking. The irony exists because now we’re trying to make investment banking (shadow banking) safer by bringing it back under the Fed’s control.

Before 1933 and Glass-Steagall most large banks carried on both commercial banking and investment banking functions. Today’s JP Morgan Chase (commercial bank) and Morgan Stanley (investment bank) are the successors of JP Morgan, an institution that combined commercial banking and investment banking operations under one roof.

Here’s what happened. Commercial banks are centuries old. They made short-term self-liquidating loans to businesses that wished to acquire inventories for prompt resale. These commercial loans were called self-liquidating because the sale of the inventories provided the proceeds for the loans’ repayment. A modern example might be a retailer borrowing from the bank to purchase toys for the Christmas season, followed by the prompt repayment of the loan from Christmas revenues.

Investment banking arose in the 19th century to provide railway funding. Railroads were huge undertakings that required large amounts of capital for construction and rolling stock. They could not build on a pay-as you-go basis. The road had to be completed before any revenue could be generated. That made it difficult for railways to raise the necessary funds. The investment banks assisted by buying the railways’ stocks and bonds, and paying for those securities by issuing checking accounts to the railways in exchange. This was known as securities underwriting, and the investment banks resold the securities to their customers.

Banks engaged in both commercial banking and investment banking, but investment banking was much riskier because the securities could fall in value before resale while the checking account the bank had issued would not. That’s what happened in the Great Depression. Stocks lost 90% of their value from 1929 to 1933, wiping out banks’ assets and their ability to meet their obligations (depositors’ checking accounts).

Congress passed and President Roosevelt signed the Glass-Steagall Act in 1933 in order to avoid similar disasters in the future. Henceforth banks would have to decide if they wished to be commercial banks or investment banks. If they wished to be commercial banks, they could no longer underwrite corporate securities. If they wished to be investment banks they could not issue checking accounts or hold bank deposits for customers. The idea was to keep bank deposits safe by removing them from the fluctuations of the stock market. Investment banks would have to work with their own funds or borrowed funds.

The Glass-Steagall Act was repealed in 1999, but commercial banking and investment banking activities remain separate under the law. That’s why the current attempt to bring “shadow banking” (i.e. investment banking) under the Fed’s purview is so ironic. It once was under the Fed’s oversight, until investment banking was separated from commercial banking to protect depositors. Now that investment banking has evolved to the point that it borrows huge sums to fund risky investments, and thereby threatens the solvency of the commercial banks, we’re bringing investment banks back under the Fed’s control.

© 2008 Michael B. Lehmann