Why the demise of Glass-Steagall helped trigger the 2008 financial meltdown that cost millions of Americans their jobs, homes and savings
This month is the eighth anniversary of the all-enveloping 2008 financial crisis. Wall Street apologists and many of their Washington, D.C., acolytes argue there is zero evidence that the takedown of the Glass-Steagall Act had anything to do with the meltdown, but the assertion ignores the role the rule of unintended consequences played in the crisis.
Glass-Steagall was enacted during the Great Depression to separate Main Street from Wall Street, creating a firewall between consumer-oriented commercial banks and riskier, more speculative investment banks. During the six-plus decades the law was in effect, there were few large bank failures and no financial panics comparable to what happened in 2008.
In the 1980s, Sandy Weil, one of the godfathers of modem finance, began acquiring control of various banks, insurance companies, brokerage firms and similar financial institutions. These were cobbled together into a conglomerate under the umbrella of a publicly traded insurance company known as Travelers Group.
In 1998 Weil proposed a $70 billion merger with Citicorp, America’s second-largest commercial bank. It would be the biggest corporate merger in American history and create the world’s largest one-stop financial services institution.
Touting the need to remain competitive in a globalized industry and customers’ desire for a “one-stop shop” (a supermarket bank), both companies lobbied hard for regulatory approval of the merger. Advocates argued that customers preferred to do all their business -life insurance, credit cards, mortgages, retail brokerage, retirement planning, checking accounts, commercial banking, and securities underwriting and trading -with one financial institution.
But the merger’s one-stop-shopping approach would make a mockery of the Glass-Steagall firewall. The proposed transaction violated its prohibition of combining a depository institution, such as a bank holding company, with other financial companies, such as investment banks and brokerage houses.
Citigroup successfully obtained a temporary waiver for the violation, then intensified decades-old efforts to eliminate the last vestige of depression-era financial market regulation so it could complete themerger. A Republican Congress passed the Financial Services Modernization Act and President Clinton signed it in November 1999. It permitted insurance companies, investment banks, and commercial banks to combine and compete across products and markets, hammering the final nail into the coffin of Glass Steagall.
Now liberated, the banking industry embarked upon a decade of concentrating financial power in fewer and fewer hands. Acquisitions of investment banks by commercial banks, such as FleetBoston buying Robertson Stephens and Bank of America buying Montgomery Securities, became commonplace.
Traditional investment banks suddenly faced competition from publicly traded commercial banks with huge reserves of federally insured deposits. The investment banks faced pressure to deliver returns on equity comparable to those of the new financial supermarkets, which also put competitive pressure on traditional investment banking businesses such as mergers and acquisitions, underwriting, and sales and trading.
In response, the investment banks sought to raise their leverage limits so they could borrow more money to engage in proprietary, speculative trading activities. In 2005 they convinced the Securities Exchange Commission to abolish the “net capital” rule that restricted the amount of debt these firms could take from 12-1 to 30-1, meaning the banks could borrow 30 dollars for every dollar of equity they held.
By 2008, increased leverage and speculation on toxic assets would ravage investment banking, leading to the collapse, merger, or restructuring of all five major Wall Street investment banks. During a six month period, Bear Stearns collapsed into the arms of JP Morgan, Lehman Brothers filed for bankruptcy protection, Merrill Lynch merged into Bank of America, and Goldman Sachs and Morgan Stanley converted to bank holding companies, giving them access to precious short-term funds from the Federal Reserve’s discount window.
The demise of Glass-Steagall may not have been at the heart of the 2008 financial crisis but it certainly contributed to the lunacy of financial deregulation. Had the law not been neutered, it would have lessened the depth and breath of the crisis that cost millions of Americans their jobs, homes and savings.
Originally Published: Sep 3, 2016