The Repeal of the US Banking Act 1933 - Essay Example

? The repeal of the US Banking Act 1933 Effect on the Global Banking Crisis of 2007 - 2008 The US Banking Act of 1933 was implemented as a response to the banking crisis that occurred during the Great Depression. Ironically, the repeal of the Glass-Steagall Act was a factor in the development of the banking crisis of 2007 - 2008. The regulatory environment created by the Glass-Steagall Act to create divisions in the banking system gave way to a deregulatory atmosphere where commercial and investment activities by one firm where permitted. In order to understand how repealing legislation implemented during the Great Depression led to the global banking crisis of 2007 – 2008, the paper will provide a historic background for the legislation of the Glass-Steagall Act, why the banking institutions wanted to repeal the legislation, and examine the creative financial instruments in the banking industry when the Glass-Steagall Act was repealed. US Banking Act of 1933 On October 29, 1929, the Dow Jones Industrial Average crashed and with it, the wealth of banks and investors vanished. Commercial banks could not legally purchase stocks but the banks created subsidiaries that allowed them to engage in investment banking and brokerage activities (White, E 1990). Before the stock market crashed on that faithful day, the deregulatory environment allowed banks to speculate in the stock market by buying on margin. The expansion of bank brokerage loans used for margin helped created the speculative bubble in the stock market before to the crash (White, E 1990). Banks used deposits from its customers to generate revenue. The deposits would be used for loans to businesses for expansion and to consumers to purchase goods. With the rapid growth of corporations during the 1920’s, firms relied less on loans from banks for expansion and issued stock to raise funds. This action by the firms caused the banks to look for other ways to generate revenue and subsequently banks generated revenue from the deposits by investing in the stock market. Banks increased their brokerage service activity to replace the lost fees from the decrease in loan revenue (White, E 1990). The stock market crash had a ripple effect throughout the economy, especially in the banking industry. On Black Tuesday, the revenue streams and the customer’s deposits vanished. The banking system had been distressed after the 1929 stock market crash (Baron, R, & Scinta, S 1996). Customers attempting to recover their deposits from the banks found the banks closed because the banks had no supply of money for the customers. Many banks failed after the crash because of illiquidity and a domino effect of bank depositors demanding their savings (Asher, J 1981). The stock market crash and ensuing bank failures was the beginning of the Great Depression and customer’s lack of faith in the banking industry. More than 9,000 banks had ceased operations between 1929 and 1932 resulting in the public losing confidence in US banking system (Crafts, N 2008). Franklin Roosevelt won the presidential election of 1932 and promised Americans a New Deal and part of the New Deal was restoring the citizen’s faith in the US banking system. In an effort to restore the lost confidence, President Roosevelt created the Emergency Banking Act on March 6, 1933 (Baron, R, & Scinta, S 1996). The first activity of the Banking Act was to declare a banking holiday that closed the US banks and the financial health of the banks was inspected for solvency during this period. Additional regulatory measures were accomplished by President Roosevelt to address the banking crisis during the Great Depression and on June 16, 1933 the Glass-Steagall Act was passed. The Glass-Steagall Act disallowed banks from conducting investment banking (Baron, R, & Scinta, S 1996). Specifically, it denied commercial banks creating securities processes except purchasing and selling via authorization for client’s accounts (Asher, J 1981). The severance of commercial banking and the investment houses was prescribed in reaction to disclosures of the corruptness and influence of the stock exchange by the commercial banks, specifically Morgan, which coordinated corporate mergers for its private profit and granted special access to company stock by political leaders and businessmen. (McLaughlin, M 1999) This type of insider trading was commonplace in the speculative environment before the stock market crashed in 1929. Banks that had commercial banking and investment activities had to change their business plan to focus on just one division. If the bank chose to focus its major business activities in commercial banking, then only 10% of their revenue could derive from securities (What was the Glass-Steagall Act? N.d.). The Glass-Steagall Act aimed to curtail one of the concerns with commercial banks using customer savings deposits to purchase risky assets. Financial heavyweights during this era, such as JP Morgan and Company, were besieged and required to trim their services and lose a core stream of revenue (What was the Glass-Steagall Act? N.d.). Repeal of the Glass-Steagall Act Since the Great Depression, there have been repeated attempts to repeal the Glass-Stegall Act to deregulate the banking industry. The limitations enforced by the Glass-Steagall Act have been gradually relaxed during the last twenty years of the twentieth century because of pressure from the banking industry, which looked for more profitable activities for their assets, especially in the thriving stock market (McLaughlin, M 1999). The US banking concerns protested that foreign banks were not subjected to restrictions for their financial assets. The methodical disassembling of the Glass-Steagall Act by financial intermediaries was set in motion in 1980 and finally succeeded in 1999 (Gilani, S 2009). The banking crisis of 2007 – 2008 began with a series of Congressional legislations that open the door to the expansion of the subprime market. The Depository Institutions Deregulation and Monetary Control Act of 1980 eliminated usury caps that had restricted the interest rates financial institutions can charge on primary mortgages, which gave banks more motive to craft home loans to customers with subpar credit (Birger, J, 2008). The Alternative Mortgage Transactions Parity Act of 1982 allowed the banks to create the various mortgage products that lead to the banking meltdown in 2007 – 2008 (Birger, J, 2008). The Garn-St. Germain Depository Institutions Act of 1982 permitted banks to participate in the money market. The Basel Accord instituted capital responsibilities for commercial banks that accept deposits. Commercial lenders had to appropriate substantial reserves for their mortgage assets but marketable mortgage assets that could be sold would not necessitate substantial reserves (Gilani, S 2009). To circumvent the reserve requirement so funds could be used to generate revenue, commercial banks shifted away from initiating and possessing mortgages to packaging the mortgage assets for securitization. This paradigm shift in the banking industry lead away from creating mortgage assets based on quality to producing mortgage assets based on liquidity (Gilani, S 2009). These legislative activities provided modifications to the Glass-Steagall Act, but the final death blow to Glass-Steagall occurred in 1999. Congress passed on November 12, 1999 The Financial Services Modernization Act, which attempted to modernize the banking industry and to repeal the Glass-Steagall Act that prevented commercial banks from offering investment and insurance services (Gramm-Leach-Bliley Act of 1999 (GLBA) Definition, 2011). The Financial Services Modernization Act eliminated the regulatory efforts created by Franklin Roosevelt that addressed the banking crisis during the Great Depression. The legislation is also called the Gramm-Leach-Bliley Act of 1999. The Gramm-Leach-Bliley Act connected the banking and the insurance systems instantly to the volatile US stock exchanges and, as a result, any substantial downtrend in stock prices had a prompt and disastrous influence on the US financial structure (McLaughlin, M 1999). Lobbyists wanted and received the deregulatory legislation to permit competition in the banking system. The financial industry lobbyists had aggregated their powers to create a deregulatory environment in the banking system. The lobbyists spent more than $300 million on the deregulatory activities that included $58 million in campaign donations to Democratic and Republican politicians campaigning for office, $87 million in gifts to the Democratic and Republican parties, and $163 million for officials that were in office (McLaughlin, M 1999). Texas Republican Phil Gramm, the presiding officer of the Senate Banking Committee, accumulated more than $1.5 million from the financial lobbyists (McLaughlin, M 1999). The Financial Services Modernization Act allowed the formation of commercial bank subsidiaries to generate revenues from investment and insurance services. The Act legalized the formation of multinational corporations that were occurring in the years preceding the passage of the Financial Services Modernization Act by Congress. In 1981, Bank America purchased Charles Schwab (discount broker), in 1987 Citicorp and J.P. Morgan began to process municipal bonds and mortgage-backed securities, and in 1998 Citicorp merged with the Travelers Group (Akhigbe, A, & Whyte, A 2001, p. 121). The deregulation of the banking system permitted additional streams of revenue to flow into commercial banks that the Glass-Steagall Act prevented. The passage of the Gramm-Leach-Bliley Act of 1999 allowed banking conglomerates to develop business models that offered customers one stop shopping for deposits, loans, investments, and mortgages. Citigroup was created from the merger of Citicorp and the Travelers Group. The $72 billion agreement joined Citibank, the largest bank in New York, and Travelers Group Inc., the vast insurance and financial services corporation, who possessed Salomon Smith Barney, a leader in the brokerage industry. (McLaughlin, M 1999) The deregulation atmosphere allowed corporations to grow, which made it difficult to manage, but it was created to cut costs and increase earnings for the shareholders. The Citicorp and Travelers merger triggered unprecedented bank combinations and mergers in the US (Grant, J 2010). Many mergers were created but not all the divisions for these multinationals generated equal profitably for the parent company. This occurred because the business model assumed that consumers would conduct all their financial business under one roof (Grant, J 2010). The business model born from the deregulation acts of Congress of the Gramm-Leach-Bliley Act of 1999 would lead to the banking crisis of 2007 – 2008. Bank of America was created from Nation’s Bank’s purchase of Bank America Corporation in 1998 (Grant, J 2010). Bank of America, during this deregulatory era, wanted to expand its footprint throughout the US. In 2004 Bank of America purchased FleetBoston Financial Corporation, in 2006 it purchased MBNA, in 2007 it acquired US Trust, in 2008 it acquired Countrywide Financial, and in 2009 purchased Merrill Lynch (Grant, J 2010 p. 401). Bank of America, through acquisition, became a major player in the deregulatory environment with operations in retail banking, mortgages, and investing. Both Citigroup and Bank of America attempted to merge the traditional retail banking sector with the risk-taking investment sector. Similar types of mergers in the financial industry would lead to the banking crisis of 2007 – 2008. Deregulatory banking crisis The mixing of the conservative banking environments and the risk-taking investment segments during deregulation would eventually lead to a banking crisis and the Great Recession of 2008. Commercial banks and investment banks made irresponsible gambles using comingled money. The financial multinationals produced and advertised unusual investment products to generate revenue and some of these risky products were well hidden in their financials. Deregulation allowed these financial intermediaries to produced mortgage back securities that created a housing bubble and when the loans when into default, massive foreclosures soon followed. The banking crisis was caused by the deregulatory environment created by the abolishment of the Glass-Steagall Act. The repeal of the 1933 Act resulted in the deregulation of the derivatives and mortgage brokers and, as a result, permitted extreme financial creativeness, risk taking, and greediness in the ranks of the financial multinationals. Since the deregulation process began in 1980, the financial system has relied on self-regulation by the banking conglomerates. The deregulation apparatus was supported by past Federal Reserve chairman Alan Greenspan, defended by sequential administrations and Congresses, and energetically lobbied by the dominant financial industry that caused cracks in supervision of vital matters with trillions of dollars at risk (Financial crisis inquiry commission, 2011). The lobbyists found a friend and sponsor of the bill to finally derail the provisions of the Glass-Steagall Act. Senator Gramm systematically used his PhD in economics and free-market philosophy knowledge to advocate the qualities of subprime lending (Gilani, S 2009). From 1989 through 2002, federal information affirms that Senator Gramm was an acquirer of lobbying gifts from banking concerns and among the top five beneficiaries of campaign donations from Wall Street firms (Gilani, S 2009). Senator Gramm was at the forefront to create an environment of government deregulation of the investment and commercial banking systems that significantly lead to the subprime mortgage crisis The subprime mortgage crisis is an ongoing real estate crisis and financial crisis triggered by a dramatic rise in mortgage delinquencies, foreclosures, overheating of real estate and debt markets, and failures in CDSs and more generally in reverse trading in the United States, with major adverse... . This included permitting the self-regulation of Wall Street's finance banks and the botched regulation of Wall Street rating activities. In 2000, Senator Phil Gramm (R-Texas) connected a 262-page rider to an appropriations measure to deregulate derivatives trading and additional complex financial tools like collateral debt obligations (Smith, D. 2008). The ratification of the 2000 legislation to prohibit the regulation by the federal and state governments of over-the-counter (OTC) derivatives was a fundamental occasion down the path toward the financial crisis (Financial crisis inquiry commission, 2011). The deregulation of OTC derivatives was a factor to the ensuing banking crisis of 2007 - 2008. Credit default swaps was a derivative that supplied financial firms with a stream of revenue in the mortgage securitization channel. Credit default swaps were provided to investors to guard against the default or decrease in value of mortgage securities supported by risky loans (Financial crisis inquiry commission, 2011). The credit default swaps was used as insurance against the new mortgage products created when the process to repeal the Glass-Steagall Act started in the 1980’s. The Alternative Mortgage Transactions Parity Act of 1982 allowed the financial firms to develop various mortgage commodities that lead to the banking crisis in 2007 – 2008 (Birger, J, 2008). The housing bubble that preceded the banking crisis was due in part from making home ownership affordable. Commercial banks traditionally provided conventional 30 year mortgages to potential homeowners. Complex mortgages replaced the conventional mortgages when the banking industry became deregulated. The new mortgage tools altered the qualifying process and increased the risks to the banking industry by allowing a lower monthly housing payment. Mortgage lenders offered adjustable-rate mortgages, balloon-payment mortgages, interest-only mortgages, and the option-adjustable-rate mortgage. The option-adjustable-rate mortgage allowed homeowners to pay less than they had to pay during the beginning years of their loan but the unpaid monthly interest was added to the loan (Birger, J, 2008). The deregulatory atmosphere increased risky subprime products and mortgage securitization, a fragile increase in housing prices, accounts of flagrant and greedy lending procedures, increase in mortgage debt, and growth in banks trading of unregulated derivatives (Financial crisis inquiry commission, 2011). Similar to the speculative environment leading up to the stock market bubble and eventual crash of 1929, the deregulation of the banking industry took advantage of the unknowing public to make massive revenue gains, which led to the housing bubble and eventual banking crisis of 2007 – 2008. The chairman of the Federal Reserve Board Chairman Ben Bernanke indicated the Federal Reverse’s lack of assertiveness in regulating the mortgage environment during the housing explosion was a disappointment (Financial crisis inquiry commission, 2011). Conclusion The US Banking Act of 1933, also known as Glass-Stegall Act, was a regulation put in place to address the banking crisis and it was created because of the stock market crash of 1929. The Glass-Steagall Act separated commercial and investment banking activities. Ironically, the deregulatory effects created with the repeal of the Glass-Steagall Act allowed the merging of commercial and investment corporations. The creative mortgage products by the enlarged firms played a major role in the maturation of the housing bubble and the collapse of the banking system during 2007 – 2008. References Akhigbe, A, & Whyte, A 2001, 'The market's assessment of the Financial Services Modernization Act of 1999', Financial Review, 36, 4, p. 119, Business Source Premier, EBSCOhost, viewed 30 March 2011. Asher, J 1981, 'Glass-Steagall: A fresh look', ABA Banking Journal, 73, 2, p. 62, Business Source Premier, EBSCOhost, viewed 30 March 2011. 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