Friday, August 31, 2012

Why we need to introduce a Glass-Steagall-style law into British banking!

I wish to acknowledge the work of James Rickards, a hedge fund manager in New York City and the author of "...Currency Wars: The Making of the Next Global Crisis..." I have borrowed heavily from his work in writing this piece and all the text in italics is taken from his website.

The (global) financial crisis might not have happened at all but for the 1999 repeal of the Glass-Steagall law that separated commercial and investment banking for seven decades. If there is any hope of avoiding another meltdown, it's critical to understand why Glass-Steagall repeal helped to cause the crisis. Without a return to something like Glass-Steagall, another greater catastrophe is just a matter of time.
Following the Great Crash of 1929, one of every five banks in America failed. Many people, especially politicians, saw the unbridled market speculation engaged in by banks during the 1920s as a cause of the crash.

In 1933, Senator Carter Glass (D-Va.) and Congressman Henry Steagall (D-Ala.) introduced the historic legislation that bears their name, seeking to limit the conflicts of interest created when commercial banks are permitted to underwrite stocks or bonds. In the early part of the century, individual investors were seriously hurt by banks whose overriding interest was promoting stocks of interest and benefit to the banks, rather than to individual investors. The new law banned commercial banks from underwriting securities, forcing banks to choose between being a simple lender or an underwriter (brokerage), thus putting a legal wall between retail and investment banking.

The Glass-Steagall Act passed after Ferdinand Pecora, a politically ambitious former New York City prosecutor, drummed up popular support for stronger regulation by hauling bank officials in front of the Senate Banking and Currency Committee to answer for their role in the stock-market crash.

It is of some interest to look at the similarities between the reasons behind the banking crash of 1929, and the global crisis which began in 2008.
The subprime crisis which was the catalyst for the global financial crisis came about in large part because of financial instruments such as debt securitization where banks would pool their various loans into sellable assets, thus off-loading risky loans onto others. (For banks, millions can be made in money-earning loans, but they are tied up for decades. So they were turned into securities. The security buyer got regular payments from all those mortgages; the banker off loaded the risk. Securitization was seen as perhaps the greatest financial innovation in the 20th century.)
Rating agencies were paid to rate these products (risking a conflict of interest) and invariably they gave them good ratings, thus encouraging other people to invest in them. 
Banks borrowed even more money to lend out so they could create more securitization. Some banks didn’t need to rely on savers as much then, as long as they could borrow from other banks and sell those loans on as securities; bad loans would be the problem of whoever bought the securities.

Some investment banks like Lehman Brothers got into mortgages, buying them merely in order to securitize them and then sell them on.Some banks loaned even more to have an excuse to securitize those loans.

Running out of investors to lend to, banks turned to the poor; the subprime, the riskier loans. Rising house prices led lenders to think it wasn’t too risky; bad loans meant repossessing high-valued property. Subprime and “self-certified” loans (sometimes dubbed “liar’s loans”) became popular, especially in the US.

Some banks evens started to buy securities from others, while high street banks got into a form of investment banking, buying, selling and trading risk. Investment banks, not content with buying, selling and trading risk, got into home loans, mortgages, etc without the right controls and management.

The problem was so large, banks even with large capital reserves ran out, so they had to turn to governments for bail out. New capital was injected into banks to, in effect, permit  them to lose more money without going bust. That still wasn’t enough and confidence was not restored.
Shrinking banks suck money out of the economy as they try to build their capital and are nervous about loaning. Meanwhile businesses and individuals that rely on credit find it harder to get. A spiral of problems result. It had depressing similarities to the era of the Wall Street Crash in the USA in 1929.
 After the Depression of 1920-21, the United States embarked on a period of economic prosperity known as the Roaring Twenties. It was a time of innovation, especially in consumer goods such as automobiles, radio, and refrigeration. Along with these goods came new forms of consumer credit and bank expansion. National City Bank (forerunner of today's Citibank) and Chase Bank opened offices to sell securities side-by-side with traditional banking products like deposits and loans.
As the decade progressed, the stock market boomed and eventually reached bubble territory. Along with the bubble came market manipulation in the form of organized pools that would ramp up the price of stocks and dump them on unsuspecting suckers just before the stock collapsed. Banks joined in by offering stocks of holding companies that were leveraged pyramid schemes and other securities backed by dubious assets.
In 1929, the music stopped, the stock market crashed and the Great Depression began. It took eight years from the start of the boom to the bust. Subsequent investigations revealed the extent of the fraud that preceded the crash. In 1933, Congress passed Glass-Steagall in response to the abuses. Banks would be allowed to take deposits and make loans. Brokers would be allowed to underwrite and sell securities. But no firm could do both due to conflicts of interest and risks to insured deposits. From 1933 to 1999, there were very few large bank failures and no financial panics comparable to the Panic of 2008. The law worked exactly as intended.
In 1999, Democrats led by President Bill Clinton and Republicans led by Sen. Phil Gramm joined forces to repeal Glass-Steagall at the behest of the big banks. What happened over the next eight years was an almost exact replay of the Roaring Twenties. Once again, banks originated fraudulent loans and once again they sold them to their customers in the form of securities. The bubble peaked in 2007 and collapsed in 2008. The hard-earned knowledge of 1933 had been lost in the arrogance of 1999.
Now, when memories are fresh, is the time to reinstate Glass-Steagall to prevent a third cycle of fraud on customers. Without the separation of banking and underwriting, it's just a matter of time before banks repeat their well-honed practice of originating garbage loans and stuffing them down customers' throats. Congress had the answer in 1933. Congress lost its way in 1999. Now is the chance to get back to the garden.
That is an informed US viewpoint. The same risks are still prevalent in the British banking sector, and Government must think very carefully about ring-fencing the role of retail banking in the UK and put a clear demarcation between them and the casino banking practices which have caused so much damage to our finances and our economy. We cannot trust the banksters to agree to this reform, they must be driven to accept the inevitable.
The recommendation of the Vickers Commission is that UK banks’ retail operations should be “ring-fenced”. Banks will be required to establish a separate legal entity within their corporate group to provide retail and commercial banking services in the UK.  The purposes of this subsidiarisation are, first, to insulate retail banking operations from riskier financial activities and risks inherent in the global financial system and, secondly, in the event of failure, to ensure the continuous provision of retail banking services by ring-fenced banks, with reduced bail-out costs for taxpayers.
Such a reform must be insisted upon and become an electoral issue!


AbogadoNZ said...

I couldn't agree more about the need to make this an election issue if it is not sorted out before. Retail banking has to be separated from 'wholesale' and both sides need new regulation. Speculative, computer driven trades have to go - there is no room in the financial services sector for ANY form of casino behaviour. Hedge funds can do it if they like but again a whole new regulatory environment is required there too!

Hawkeye said...

Hi Rowan

You are right to highlight the importance of this most profound de-regulation.

In 2010 I submitted the following critique to the Vickers commission / ICB:

What we need is even more profound than just the legal separation of wholesale and retail banking, as the very act of "securitisation" transcends both types of bank anyway.

My paper also makes very good use of the Akerlof & Romer 1993 paper on "Looting: Bankruptcy for profit":

It is clear that modern banking is engaged in wholesale fraud & looting. See section 7 of my ICB report for a summary of their framework and how it applies to modern banking.